UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

 

Commission file number 1-16411

 

NORTHROP GRUMMAN CORPORATION

(Exact name of registrant as specified in its charter)

 

 

1840 Century Park East, Los Angeles, California 90067

www.northropgrumman.com

(Address of principal executive offices and internet site)

 

(310) 553-6262

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

As of October 22, 2007, 338,361,747 shares of common stock were outstanding.

 

 

NORTHROP GRUMMAN CORPORATION

 

Table of Contents

 

NORTHROP GRUMMAN CORPORATION

 

PART I. FINANCIAL INFORMATION

 

 

CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(Unaudited)

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

NORTHROP GRUMMAN CORPORATION

 

 

CONSOLIDATED CONDENSED STATEMENTS OF FINANCIAL POSITION
(Unaudited)

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

NORTHROP GRUMMAN CORPORATION

 

 

CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

NORTHROP GRUMMAN CORPORATION

 

 

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(Unaudited)

 

NORTHROP GRUMMAN CORPORATION

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

NORTHROP GRUMMAN CORPORATION

 

 

CONSOLIDATED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Unaudited)

 

 

The accompanying notes are an integral part of these consolidated condensed financial statements.

NORTHROP GRUMMAN CORPORATION

 

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Unaudited)

 

 

Principles of Consolidation – The unaudited consolidated condensed financial statements include the accounts of Northrop Grumman Corporation and its subsidiaries (the company). All intercompany accounts, transactions, and profits are eliminated in consolidation.

 

The accompanying unaudited consolidated condensed financial statements of the company have been prepared by management in accordance with the instructions to Form 10-Q of the Securities and Exchange Commission. These statements include all adjustments considered necessary by management to present a fair statement of the company’s consolidated financial position, results of operations, and cash flows. The results reported in these consolidated condensed financial statements should not be regarded as necessarily indicative of results that may be expected for the entire year. These financial statements should be read in conjunction with the Notes to Consolidated Financial Statements contained in the company’s 2006 Annual Report on Form 10-K.

 

The quarterly information is labeled using a calendar convention; that is, first quarter is consistently labeled as ending on March 31, second quarter as ending on June 30, and third quarter as ending on September 30. It is management’s long-standing practice to establish actual interim closing dates using a “fiscal” calendar, which requires our businesses to close their books on the Friday nearest these quarter-end dates in order to normalize the potentially disruptive effects of quarterly closings on business processes. The effects of this practice only exist within a reporting year.

 

Accounting Estimates – The company’s consolidated condensed financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). The preparation of the financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of commitments and contingencies at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Estimates have been prepared on the basis of the most current and best available information and actual results could differ materially from those estimates.

 

Financial Statement Reclassifications – Certain amounts in the prior period financial statements and related notes have been reclassified to conform to the 2007 presentation, due to the sale and shut down of the Interconnect Technologies (ITD) businesses as described in Note 5 and the business operation realignments described in Note 6.

 

 

The disclosure requirements and cumulative effect of adoption of the Financial Accounting Standards Board (FASB) Interpretation No. (FIN) 48 – Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 are presented in Note 14.

 

Other new pronouncements issued but not effective until after September 30, 2007, are not expected to have a significant effect on the company’s consolidated financial position or results of operations

 

 

On February 21, 2007, the company’s board of directors approved a 23 percent increase to the quarterly dividend on common stock, from $.30 per share to $.37 per share, effective with the first quarter 2007 dividend.

 

On May 17, 2006 the company’s board of directors approved a 15 percent increase to the quarterly dividend on common stock, from $.26 per share to $.30 per share, effective with the second quarter 2006 dividend.

NORTHROP GRUMMAN CORPORATION

 

 

 

Essex – On January 25, 2007, the company acquired Essex Corporation (Essex) for approximately $600 million, including the assumption of debt totaling $23 million and estimated transaction costs of $15 million. Essex provides signal processing services and products, and advanced optoelectronic imaging for U.S. government intelligence and defense customers. The operating results of Essex are reported in the Mission Systems segment. The assets, liabilities, and results of operations of Essex were not material to the company’s consolidated financial position or results of operations, and thus pro-forma information is not presented.

 

AMSEC – On July 13, 2007, the company and Science Applications International Corporation (SAIC) reorganized their joint venture AMSEC, LLC (AMSEC), by dividing AMSEC along customer and product lines. AMSEC is a full-service supplier that provides engineering, logistics and technical support services primarily to Navy ship and aviation programs. Under the reorganization plan, the company retained the ship engineering, logistics and technical service businesses under the AMSEC name (the AMSEC Businesses) and, in exchange, SAIC received the aviation, combat systems and strike force integration services businesses from AMSEC (the Divested Businesses). This reorganization was treated as a step acquisition for the acquisition of SAIC’s interests in the AMSEC Businesses, with the company recognizing a pre-tax gain of $22 million during the third quarter of 2007 for the effective sale of its interests in the Divested Businesses. The operating results of the AMSEC Businesses and transaction gain have been reported in the Ships segment. Prior to the reorganization, the company accounted for AMSEC, LLC under the equity method. The assets, liabilities, and results of operations of the AMSEC Businesses were not material to the company’s consolidated financial position or results of operations, and thus pro-forma information is not presented.

 

During the third quarter of 2007, the company acquired the remaining 60 percent of Scaled Composites, LLC for approximately $100 million in the aggregate. The assets, liabilities, and results of operations of the entities acquired were not material to the company’s consolidated financial position or results of operations, and thus pro-forma information is not presented.

 

The consolidated condensed financial statements reflect preliminary estimates of the fair value of the assets acquired and liabilities assumed in the transactions noted above and the related allocation of the purchase price for the entities acquired. Management does not expect adjustments to these estimates, if any, to have a material effect on the company’s financial position or results of operations.

 

 

2007 – During the second quarter, management announced its decision to exit the remaining ITD business reported within the Electronics segment. Sales for this business for the nine months ended September 30, 2007, and 2006, were $14 million and $27 million, respectively. The shut-down was completed during the third quarter of 2007 and costs associated with the shutdown were not material. The results of this business are reported as discontinued operations in the consolidated condensed statements of income, net of applicable income taxes, for all periods presented.

 

2006 – The company sold the assembly business unit of ITD during the first quarter of 2006 and Winchester Electronics (Winchester) during the second quarter of 2006 for net cash proceeds of $26 million and $17 million, respectively, and recognized after-tax gains of $4 million and $2 million, respectively, in discontinued operations. The results of operations of the assembly business unit of ITD are reported as discontinued operations in the consolidated condensed statements of income, net of applicable income taxes. The results of operations of Winchester, reported in the Electronics segment, were not material to any of the periods presented and have therefore not been reclassified as discontinued operations.

 

During the second quarter of 2006, the Enterprise Information Technology business, formerly reported in the Information Technology segment, was shut down and costs associated with the exit activities were not material. The results of operations of this business are reported as discontinued operations in the consolidated condensed statements of income, net of applicable income taxes.

NORTHROP GRUMMAN CORPORATION

 

 

 

Effective January 1, 2007, the company realigned businesses among its operating segments that possess similar customers, expertise, and capabilities. The realignment more fully leverages existing capabilities and enhances development and delivery of highly integrated services. The realignment primarily involved the transfer of the Radio Systems business from the Space Technology segment to the Mission Systems segment and the transfer of the UK Airborne Warning and Control System program from the Information Technology segment to the Technical Services segment. On July 1, 2006, certain logistics, services and technical support programs were transferred from Electronics, Integrated Systems, Mission Systems, and Space Technology to Technical Services. The sales and segment operating margin in the following tables have been revised, where applicable, to reflect these realignments for all periods presented.

 

The following table presents segment sales and service revenues for the three and nine months ended September 30, 2007, and 2006.

 

NORTHROP GRUMMAN CORPORATION

 

The following table presents segment operating margin reconciled to total operating margin for the three and nine months ended September 30, 2007, and 2006.

 

 

Unallocated Expenses – Unallocated expenses includes the portion of corporate expenses such as management and administration, legal, environmental, certain compensation and retiree benefits, and other expenses not considered allowable or allocable under applicable United States (U.S.) Government Cost Accounting Standards (CAS) and the Federal Acquisition Regulation, and therefore not allocated to the segments.

 

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 September 30, 2007, and 2006, pension expense determined in accordance with GAAP was $89 million and $112 million, respectively, and pension expense determined in accordance with CAS amounted to $120 million and $110 million, respectively. For the nine months ended September 30, 2007, and 2006, pension expense determined in accordance with GAAP was $263 million and $337 million, respectively, and pension expense determined in accordance with CAS was $355 million and $313 million, respectively.

 

 

Basic Earnings Per Share – Basic earnings per share are calculated by dividing net income by the weighted average number of shares of common stock outstanding during each period.

 

Diluted Earnings Per Share – Diluted earnings per share includes the dilutive effect of stock options and other stock awards granted to employees under stock-based compensation plans and, for 2007, the company’s mandatorily redeemable convertible series B preferred stock (6.4 million dilutive shares). For the three and nine months ended September 30, 2006, the effect of the mandatorily redeemable convertible series B preferred stock was not dilutive to earnings per share.

NORTHROP GRUMMAN CORPORATION

 

The weighted average diluted shares outstanding for the three and nine months ended September 30, 2007, exclude the anti-dilutive effects of stock options to purchase approximately 36,000 and 72,000 shares, respectively, since such options have an exercise price in excess of the average market price of the company’s common stock during the period. The weighted average diluted shares outstanding for the three and nine months ended September 30, 2006, exclude the anti-dilutive effects of stock options to purchase approximately 8,000 and 32,000 shares, respectively.

 

Diluted earnings per share from continuing operations are calculated as follows:

 

 

Share Repurchases – On December 14, 2006, the company’s board of directors authorized a share repurchase program of up to $1 billion of its outstanding common stock. This authorization was in addition to $176 million remaining on the company’s previous $1.5 billion share repurchase authorization, which commenced in November 2005.

 

Since November 2005 the company has entered into four separate accelerated share repurchase agreements with two different banks (the Banks) to repurchase shares of common stock. In each case, shares were immediately borrowed by the Banks that were then sold to and canceled by the company. Subsequently, shares were purchased in the open market by the Banks to settle their share borrowings. The cost of the company’s share repurchases is subject to adjustment based on the actual cost of the shares subsequently purchased by the Banks. If an additional amount was owed by the company upon settlement, the price adjustment could have been settled, at the company’s option, in cash or in shares of common stock.

 

The table below summarizes the accelerated share repurchase transactions:

 

 

Share repurchases take place at management’s discretion or under pre-established, non-discretionary programs from time to time, depending on market conditions, in the open market, and in privately negotiated transactions.

NORTHROP GRUMMAN CORPORATION

 

The company retires its common stock upon repurchase and has not made any purchases of common stock other than in connection with these publicly announced repurchase programs.

 

As of September 30, 2007, the company has $82 million authorized for share repurchases.

 

 

Goodwill

 

The changes in the carrying amounts of goodwill for the nine months ended September 30, 2007, were as follows:

 

 

Fair Value Adjustments to Net Assets Acquired – The fair value adjustments were primarily due to the favorable settlement of Internal Revenue Service (IRS) audits and a claim for a tax refund.

 

Purchased Intangible Assets

 

The table below summarizes the company’s purchased intangible assets:

 

 

The company’s purchased intangible assets are subject to amortization and are being amortized on a straight-line basis over an aggregate weighted average period of 21 years. Aggregate amortization expense for the three and nine months ended September 30, 2007, was $33 and $99 million, respectively.

NORTHROP GRUMMAN CORPORATION

 

The table below shows expected amortization for purchased intangibles for the remainder of 2007 and for the next five years:

 

 

 

U.S. Government Investigations and Claims – Departments and agencies of the U.S. Government have the authority to investigate various transactions and operations of the company, and the results of such investigations may lead to administrative, civil, or criminal proceedings, the ultimate outcome of which could be fines, penalties, repayments or compensatory or treble damages. U.S. Government regulations provide that certain findings against a contractor may lead to suspension or debarment from future U.S. Government contracts or the loss of export privileges for a company or an operating division or subdivision. Suspension or debarment could have a material adverse effect on the company because of its reliance on government contracts.

 

As previously disclosed, in October 2005, the U.S. Department of Justice and a classified U.S. Government customer apprised the company of potential substantial claims relating to certain microelectronic parts produced by the Space and Electronics Sector of former TRW Inc., now a component of the company. The relationship, if any, between the potential claims and a civil False Claims Act case that remains under seal in the U.S. District Court for the Central District of California remains unclear to the company. In the third quarter of 2006, the parties commenced settlement discussions. While the company continues to believe that it did not breach the contracts in question and that it acted appropriately in this matter, the company proposed to settle the claims and any associated matters and recognized a pre-tax charge of $112.5 million in the third quarter of 2006 to cover the cost of the settlement proposal and associated investigative costs. The company extended the offer in an effort to avoid litigation and in recognition of the value of the relationship with this customer. The U.S. Government has advised the company that if settlement is not reached it will pursue its claims through litigation. Because of the highly technical nature of the issues involved and their classified status and because of the significant disagreement between the company and the U.S. Government as to the U.S. Government’s theories of liability and damages (including a material difference between the U.S. Government’s damage theories and the company’s offer), final resolution of this matter could take a considerable amount of time, particularly if litigation should ensue. If the U.S. Government were to pursue litigation and were to be ultimately successful on its theories of liability and damages, which could be trebled under the Federal False Claims Act, the effect upon the company’s consolidated financial position, results of operations, and cash flows would materially exceed the amount provided by the company. Based upon the information available to the company to date, the company believes that it has substantive defenses but can give no assurance that its views will prevail. Accordingly, the ultimate disposition of this matter cannot presently be determined.

 

As previously disclosed, on May 17, 2007, the U.S. Coast Guard issued a revocation of acceptance under the Deepwater Program for eight converted 123-foot patrol boats (the vessels) based on alleged “hull buckling and shaft alignment problems.” By letter dated June 5, 2007, the Coast Guard stated that the revocation of acceptance also was based on alleged “nonconforming topside equipment” on the vessels. On August 13, 2007, the company submitted a response to the Coast Guard, maintaining that the revocation of acceptance was improper. The contract value associated with the eight converted vessels is approximately $85 million. The Coast Guard has not specified the amount of damages sought in connection with the eight vessels. Based upon the information

NORTHROP GRUMMAN CORPORATION

 

available to the company to date, the company believes that it has substantive defenses but can give no assurance that its views will prevail. However, the company believes, but can give no assurance, that the outcome of this matter would not have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

Based upon the available information regarding matters that are subject to U.S. Government investigations, other than as set out above, the company believes, but can give no assurance, that the outcome of any such matters would not have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

Litigation – Various claims and legal proceedings arise in the ordinary course of business and are pending against the company and its properties. Based upon the information available, the company believes that the resolution of any of these various claims and legal proceedings would not have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

As previously disclosed, the company is a defendant in litigation brought by Cogent Systems, Inc. (Cogent) in Los Angeles Superior Court in California on April 20, 2005, for unspecified damages for alleged unauthorized use of Cogent technology relating to fingerprint recognition. On September 10, 2007, the company and Cogent announced that they had reached an agreement to settle the litigation. The agreement is subject to completion of definitive documents. Under the terms of the agreement, the company has agreed to pay Cogent $25 million to settle the litigation. The company also has agreed to pay Cogent $15 million for a non-exclusive license to use specified Cogent state-of-the-art automated fingerprint identification software in certain existing programs. The company and Cogent also have agreed to enter into a five-year research and development, service and products agreement, under which the company will pay Cogent $20 million for products and services over the term of the agreement. This settlement will end the litigation and allow the companies to work together on a strategic alliance to provide customers with state-of-the-art fingerprint identification technology and other biometric solutions. A substantial portion of the costs to settle this matter had been provided for earlier in 2007, and accordingly, the resolution of this matter did not have a material effect on the financial statements for the quarter ended September 30, 2007.

 

As previously disclosed, the U.S. District Court for the Central District of California consolidated two separately filed ERISA lawsuits, which the plaintiffs seek to have certified as class actions, into the In Re Northrop Grumman Corporation ERISA Litigation. On August 7, 2007, the Court denied plaintiffs’ motion for class certification. The plaintiffs sought leave to file an appeal with the U.S. Court of Appeals for the Ninth Circuit on the issue of class certification. On September 28, 2007, the Ninth Circuit ordered that the trial court proceedings be stayed pending its decision on whether to grant appellate review, and on October 11, 2007, the Ninth Circuit granted such review. The decision to grant appellate review will delay the commencement of trial previously scheduled to begin on January 22, 2008. The company believes, but can give no assurance, that the outcome of these matters would not have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

Insurance Recovery – Property damage from Hurricane Katrina is covered by the company’s comprehensive property insurance program. The insurance provider for coverage of property damage losses over $500 million, FM Global Insurance (FM Global), has advised management of a disagreement regarding coverage for certain losses above $500 million. As a result, the company has taken legal action against the insurance provider as the company believes that its insurance policies are enforceable and intends to pursue all of its available rights and remedies. In August 2007, the district court in which the litigation is pending issued an order finding that the excess insurance policy provided coverage for the company’s Katrina related loss. FM Global has advised the company that it intends to appeal the decision. Based on the current status of the assessment and claim process, no assurances can be made as to the ultimate outcome of this matter (See Note 11).

 

Provisions for Legal & Investigative Matters – Litigation accruals are recorded as charges to earnings when management, after taking into consideration the facts and circumstances of each matter, including any settlement offers, has determined that it is probable that a liability has been incurred and the amount of the loss can be

NORTHROP GRUMMAN CORPORATION

 

reasonably estimated. The ultimate resolution of any exposure to the company may vary from earlier estimates as further facts and circumstances become known.

 

 

Contract Performance Contingencies – Contract profit margins may include estimates of costs not contractually agreed to between the customer and the company for matters such as contract changes, negotiated settlements, claims and requests for equitable adjustment for previously unanticipated contract costs. These estimates are based upon management’s best assessment of the underlying causal events and circumstances, and are included in determining contract profit margins to the extent of expected recovery based on contractual entitlements and the probability of successful negotiation with the customer. As of September 30, 2007, the amounts recorded are not material individually or in the aggregate.

 

In April 2007, the company was notified by the prime contractor on the Wedgetail contract that it anticipates the prime contractor’s delivery dates will be late and this could subject the prime contractor to liquidated damages from the customer. Should liquidated damages be assessed, the company would share in a proportionate amount of those damages to a maximum of approximately $40 million. As of September 30, 2007, the company has not been notified by the prime contractor as to any claim for liquidated damages. Until such time as liquidated damages are assessed by the customer, it is not possible to determine the impact to the consolidated financial statements, if any, for this matter.

 

Environmental Matters – In accordance with company policy on environmental remediation, the estimated cost to complete remediation has been accrued where it is probable that the company will incur such costs in the future to address environmental impacts at currently or formerly owned or leased operating facilities, or at sites where it has been named a Potentially Responsible Party (PRP) by the Environmental Protection Agency, or similarly designated by other environmental agencies. To assess the potential impact on the company’s consolidated financial statements, management estimates the total reasonably possible remediation costs that could be incurred by the company, taking into account currently available facts on each site as well as the current state of technology and prior experience in remediating contaminated sites. These estimates are reviewed periodically and adjusted to reflect changes in facts and technical and legal circumstances. Management estimates that as of September 30, 2007, the range of reasonably possible future costs for environmental remediation sites was $205 million to $298 million, of which $232 million is accrued in other current liabilities. Factors that could result in changes to the company’s estimates include: modification of planned remedial actions, increases or decreases in the estimated time required to remediate, discovery of more extensive contamination than anticipated, changes in laws and regulations affecting remediation requirements, and improvements in remediation technology. Should other PRPs not pay their allocable share of remediation costs, the company may have to incur costs in addition to those already estimated and accrued. Although management cannot predict whether new information gained as projects progress will materially affect the estimated liability accrued, management does not anticipate that future remediation expenditures will have a material adverse effect on the company’s consolidated financial position, results of operations, or cash flows.

 

Income Tax Matters – The company has exposure related to income tax matters arising from indemnifications of businesses divested. The company periodically assesses these exposures for all tax years that are open under the applicable statute of limitations and records a liability, including related interest charges, where it has determined that a liability has been incurred and the amount of the loss can be reasonably estimated. Liabilities under indemnification agreements for businesses divested are recorded at fair value at the inception of the indemnification and presented within income taxes payable. These primarily relate to indemnifications of foreign taxes as a result of the divestiture of TRW Auto in 2003 and total approximately $133 million and $145 million at September 30, 2007, and December 31, 2006, respectively. Management does not believe that the resolution of any of these income tax exposures will have a material adverse effect on the company’s consolidated financial position, results of operations, or cash flows.

NORTHROP GRUMMAN CORPORATION

 

Co-Operative Agreements – In 2003, Ships executed agreements with the states of Mississippi and Louisiana whereby Ships leases facility improvements and equipment from Mississippi and from a non-profit economic development corporation in Louisiana in exchange for certain commitments by Ships to these states.

 

As of September 30, 2007, Ships has met its obligations under the Mississippi agreement and remains obligated under the Louisiana agreement to maintain a minimum average of 5,200 full-time employees in the state of Louisiana at the end of any four-year period occurring between January 1, 2003, and December 31, 2010.

 

Failure by Ships to meet the Louisiana commitment would result in reimbursement by Ships to Louisiana in accordance with the agreement. As of September 30, 2007, Ships expects that all future commitments under the Louisiana agreement will be met based on its most recent business plan.

 

Financial Arrangements – In the ordinary course of business, the company utilizes standby letters of credit and guarantees issued by commercial banks and surety bonds issued by insurance companies principally to guarantee the performance on certain contracts and to support the company’s self-insured workers’ compensation plans. At September 30, 2007, there were $435 million of unused stand-by letters of credit, $149 million of bank guarantees, and $551 million of surety bonds outstanding.

 

In December 2006, Ships entered into a loan agreement with the Mississippi Business Finance Corporation (MBFC) under which Ships received access to $200 million from the issuance of Gulf Opportunity Zone Industrial Development Revenue Bonds by the MBFC. The loan accrues interest payable semi-annually at a fixed rate of 4.55 percent per annum. The company’s obligation related to these bonds is recorded in “Long-term debt” in the consolidated condensed statements of financial position. The bonds are subject to redemption at the company’s discretion on or after December 1, 2016, and mature on December 1, 2028. The bond issuance proceeds must be used to finance the construction, reconstruction, and renovation of the company’s interest in certain ship manufacturing and repair facilities, or portions thereof, located in the state of Mississippi. As of September 30, 2007, approximately $125 million was used by Ships and the remaining $75 million was recorded in other assets as restricted cash in the consolidated condensed statement of financial position. Repayment of the bonds is guaranteed by the company.

 

Credit Facility – On August 10, 2007, the company entered into an amended and restated credit agreement amending the company’s $2 billion five-year credit facility dated August 5, 2005. The agreement extends the maturity date of the credit facility from August 5, 2010, to August 10, 2012 and provides for improved pricing terms, reduced facility fees, and full availability of the facility for letters of credit. At September 30, 2007, there was no balance outstanding under this facility.

 

Indemnifications – The company has retained certain warranty, environmental, and other liabilities in connection with certain divestitures. Except as discussed in the following paragraph, the settlement of these liabilities is not expected to have a material adverse effect on the company’s consolidated financial position, results of operations, or cash flows.

 

In May 2006, Goodrich Corporation (Goodrich) notified the company of its claims under indemnities assumed by the company in its December 2002 acquisition of TRW that related to the sale by TRW of its Aeronautical Systems business in October 2002. Goodrich seeks relief from increased costs and other damages of approximately $118 million. The parties are engaged in discussions to enable the company to evaluate and assess the amounts being claimed. If the parties are unable to reach a negotiated resolution of the claims, Goodrich will have the right to commence litigation and may seek significant additional damages relating to allegations of other incurred costs and lost profits. The ultimate disposition of any litigation could take an extended period of time due to the nature of the claims. At this time the company does not have sufficient information to determine the ultimate disposition of this matter. If Goodrich were to pursue litigation and ultimately be successful on its claims, the effect upon the company’s consolidated financial position, results of operations, or cash flows could be material.

NORTHROP GRUMMAN CORPORATION

 

U.S. Government Claims – During the second quarter of 2006, the U.S. Government advised the company of claims and penalties concerning certain potential disallowed costs. The parties are engaged in discussions to enable the company to evaluate the merits of these claims as well as to assess the amounts being claimed. The company believes, but can give no assurance, that the outcome of any such matters would not have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

Related Party Transactions – The company had no material related party transactions for any period presented.

 

 

Background – On August 29, 2005, the company’s operations in the Gulf Coast area of the United States were significantly impacted by Hurricane Katrina. The company’s shipyards in Louisiana and Mississippi sustained significant windstorm damage from the hurricane.

 

As a result of the storm, the company has incurred costs to replace or repair destroyed or damaged assets, suffered losses under its contracts, and incurred substantial costs to clean up and recover its operations. As of the date of the storm, the company had a comprehensive insurance program that provided coverage for, among other things, property damage, business interruption impact on net profitability (referred to in this discussion generally as “lost profits”), and costs associated with clean-up and recovery.

 

Insurance Coverage Summary - The company’s property insurance program at the time of loss was established in two layers of coverage. The primary (first) layer of coverage was provided by a syndicate of leading insurers and covered losses up to $500 million. The excess (second) layer of coverage was provided by a single insurer – FM Global. This excess layer reimburses the company for losses above $500 million up to the policy limit of approximately $20 billion.

 

In prior years, the company has experienced damage from other storms and events and the company has had success in obtaining recovery from its insurers for covered damages. Based on its prior experience with processing insurance claims, the company has a well-defined process for developing, analyzing and preparing its claims for insurance recovery.

 

Accounting for Insurance Recoveries – The company makes various assessments and estimates in determining amounts to record as insurance recoveries, including ascertaining whether damages are covered by insurance and assessing the viability and financial well-being of its insurers. The company and its insurers in the first layer of coverage reached an arrangement whereby the company submitted detailed requests for reimbursement of its clean-up, restoration and capital asset repair or replacement costs while its overall claim was in the process of being evaluated by the insurers. After such requests were reviewed by the insurers, progress payments against the overall coverage limits were approved by the insurers. Based on prior experience with insurance recoveries, and in reliance on the acceptance by the insurers of the company’s claim reimbursement process, the company recognized a receivable from the insurers in the first layer of coverage as costs were incurred, and offset the receivable with progress payments as received. Since the submission of its claim, the company has accrued receivables from the insurers for amounts included in the claim relating to its asset impairment and clean-up and recovery costs, offset by progress payments made by the insurers as described above.

 

In accordance with U.S. government cost accounting regulations affecting the majority of the company’s contracts, the cost of insurance premiums for all coverage other than “coverage of profit” is an allowable cost that may be charged to long-term contracts. Because the majority of long-term contracts at the shipyards are flexibly-priced, the government customer would benefit from the majority of insurance recoveries in excess of the net book value of damaged assets and the costs for clean-up and recovery. In a similar manner, losses on property damage that are not recovered through insurance are required to be included in the company’s overhead pools for allocation to long-term contracts under a systematic process. The company is currently in discussions with its government customers to determine an appropriate methodology to be used to account for these amounts for

NORTHROP GRUMMAN CORPORATION

 

government contract purposes. The company anticipates that the ultimate outcome of such discussions will not have a material adverse affect on the consolidated financial statements.

 

The company has full entitlement to insurance recoveries related to lost profits; however, because of uncertainties concerning the ultimate determination of recoveries related to lost profits, in accordance with company policy no such amounts are recognized by the company until they are settled with the insurers. Furthermore, due to the uncertainties with respect to the company’s disagreement with FM Global, no receivables have been recognized by the company in the accompanying consolidated condensed financial statements for insurance recoveries from the second insurance layer.

 

Insurance Claim – The company’s Hurricane Katrina insurance claim is continually being evaluated based on actions to date and an assessment of remaining recovery scope. The company updated its assessment during the third quarter of 2007 and, as a result, the company’s aggregate claim for insurance recovery as a result of Hurricane Katrina is estimated to be $1.1 billion, consisting of clean-up and restoration costs of $278 million, property damages (including the value of destroyed assets not replaced) and other capital expenditures of $492 million and lost profits of $318 million. Certain amounts within the overall claim are still in the process of being finalized and the overall value of the claim may change from these amounts.

 

In June 2007, the company reached a final agreement with all but one of the insurers in its first layer of coverage under which the insurers agreed to pay their policy limits (less the policy deductible and certain other minor costs). As a result of the agreement regarding the claims from the first layer of coverage, the company received a total insurance recovery for damages to the shipyards of $466 million reflecting policy limits less certain minor costs. The company is continuing to seek recovery of its claim from the remaining insurer in the first layer that did not participate in the agreement. As a result of the agreement, the company received final cash payments totaling $113 million in the quarter ended June 30, 2007, of which $62 million has been attributed to the recovery of lost profits due to the storm and this amount was recognized in the consolidated condensed statement of income for that period as an adjustment to operating margin (cost of product sales) in the Ships segment. Through September 30, 2007, cumulative proceeds from the agreement have also been used to fund $126 million in capital expenditures for assets fully or partially damaged by the storm and $278 million in clean-up and restoration costs. Insurance recoveries received to date have enabled the company to recover the entire net book value of $98 million of assets totally or partially destroyed by the storm. To the extent that the company is unsuccessful in receiving the full value of its remaining claim relating to capital assets, the company will be responsible for funding the capital expenditures necessary to operate its shipyards. Through September 30, 2007, the company has incurred capital expenditures totaling $269 million related to assets damaged by Hurricane Katrina, of which approximately two-thirds represents the replacement cost of assets destroyed and the remainder represents the capitalized value of asset improvements that extended the useful life of assets damaged by the storm.

 

The company expects that its residual claim will be resolved separately with the remaining insurers in each of its two layers of coverage, and the company has pursued the resolution of its claim with that understanding. The insurer for the second layer of coverage has denied coverage for substantial portions of the company’s claim and the parties are presently in litigation to resolve this matter. In August 2007, the district court in which the litigation is pending issued an order finding that the excess insurance policy provided coverage for the company’s Katrina related loss. The insurer has advised the company that it intends to seek an appeal of the decision. (see Note 9).

 

Aside from contract cost adjustments recognized immediately following the hurricane and the subsequent effects of lower contract margins thereafter resulting from hurricane related cost growth, delay and disruption to contracts-in-progress, no other Hurricane Katrina related losses have been, or are expected to be, experienced by the company.

NORTHROP GRUMMAN CORPORATION

 

 

 

The cost of the company’s pension plans and medical and life benefits plans is shown in the following table:

 

 

Employer Contributions – At a minimum, the company expects to make required contributions of approximately $139 million to its pension plans and approximately $183 million to its medical and life benefit plans in 2007. As of September 30, 2007, contributions of $126 million and $124 million have been made to the company’s pension plans and its medical and life benefit plans, respectively.

 

 

At September 30, 2007, the company had stock-based awards outstanding under the following plans: the 2001 Long-Term Incentive Stock Plan and the 1993 Long-Term Incentive Stock Plan, both applicable to employees, the 1993 Stock Plan for Non-Employee Directors and the 1995 Stock Plan for Non-Employee Directors, as amended. All of these plans were approved by the company’s shareholders. Share-based awards under the employee plans consist of stock option awards (Stock Options) and restricted stock awards (Stock Awards).

 

Compensation Expense – Total pre-tax stock-based compensation for the nine months ended September 30, 2007, was $135 million, of which $9 million related to Stock Options and $126 million related to Stock Awards, respectively. Total pre-tax stock-based compensation for the nine months ended September 30, 2006, was $155 million, of which $8 million related to Stock Options and $147 million related to Stock Awards, respectively. Tax benefits recognized in the consolidated condensed statements of income for stock-based compensation during the nine months ended September 30, 2007, and 2006, were $53 million and $54 million, respectively. In addition, the company realized excess tax benefits of $51 million and $47 million, respectively, from the exercise of Stock Options and $22 million and $5 million, respectively, from the vesting of Stock Awards in the nine months ended September 30, 2007, and 2006.

 

Stock Options – The fair value of each of the company’s Stock Option awards is estimated on the date of grant using a Black-Scholes option-pricing model that uses the assumptions noted in the table below. The fair value of the company’s Stock Option awards is expensed on a straight-line basis over the vesting period of the options, which is generally four years. Expected volatility is based on an average of (1) historical volatility of the company’s stock and (2) implied volatility from traded options on the company’s stock. The risk-free rate for periods within the contractual life of the Stock Option award is based on the yield curve of a zero-coupon U.S. Treasury bond on the date the award is granted with a maturity equal to the expected term of the award. The company uses historical data to estimate forfeitures within its valuation model. The expected term of awards

NORTHROP GRUMMAN CORPORATION

 

granted is derived from historical experience under the company’s stock-based compensation plans and represents the period of time that awards granted are expected to be outstanding.

 

The significant weighted average assumptions relating to the valuation of the company’s Stock Options for the nine months ended September 30, 2007, and 2006, were as follows:

 

 

The weighted average grant date fair value of Stock Options granted during the nine months ended September 30, 2007, and 2006, was $15 and $18 per share, respectively.

 

Stock Option activity for the nine months ended September 30, 2007, was as follows:

 

 

The total intrinsic value of options exercised during the nine months ended September 30, 2007, and 2006, was $129 million and $134 million, respectively. Intrinsic value is measured using the fair market value at the date of exercise (for options exercised) or at September 30, 2007 (for outstanding options), less the applicable exercise price.

 

Stock Awards – Compensation expense for Stock Awards is measured at the grant date based on fair value and recognized over the vesting period. The fair value of Stock Awards is determined based on the closing market price of the company’s common stock on the grant date. For purposes of measuring compensation expense, the amount of shares ultimately expected to vest is estimated at each reporting date based on management’s expectations regarding the relevant performance criteria. In the table below, the share adjustment resulting from the final performance measure is considered granted in the period that the related grant is vested. During the nine months ended September 30, 2007, 2.6 million shares of common stock were issued to employees in settlement of prior year Stock Awards that were fully vested, with a total value upon issuance of $199 million and a grant date fair value of $125 million. During the nine months ended September 30, 2006, 2.4 million shares of common stock were issued to employees in settlement of prior year Stock Awards that were fully vested, with a total value upon issuance of $155 million and a grant date fair value of $132 million. There were 3.4 million Stock Awards granted in the nine months ended September 30, 2006, with a weighted average grant date fair value of $65 per share.

NORTHROP GRUMMAN CORPORATION

 

Stock Award activity for the nine months ended September 30, 2007, was as follows:

 

 

Unrecognized Compensation Expense – At September 30, 2007, there was $246 million of unrecognized compensation expense related to unvested awards granted under the company’s stock-based compensation plans, of which $19 million relates to Stock Options and $227 million relates to Stock Awards. These amounts are expected to be charged to expense over a weighted average period of 1.5 years.

 

 

The company’s effective tax rates on income from continuing operations were 32.3 percent and 30.2 percent for the nine months ended September 30, 2007 and 2006, respectively. During the nine months ended September 30, 2007, the company reached a partial settlement agreement with the IRS regarding its audit of the company’s tax years ended 2001 – 2003. As a result, the company recognized a net tax benefit of $22 million due to the reversal of previously established expense provisions. During the nine months ended September 30, 2006, the company reached final approval with the IRS regarding its audit of the company’s B-2 program for the years ended December 31, 1997 through December 31, 2000. As a result, the company recognized a net tax benefit of $48 million due to the reversal of previously established expense provisions. The company also recognized a net tax benefit of $18 million in 2006 related to tax credits associated with qualified wages paid to employees affected by Hurricane Katrina.

 

The company adopted the provisions of FIN 48 – Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, on January 1, 2007. As a result of the implementation of FIN 48, the company made a comprehensive review of its portfolio of uncertain tax positions in accordance with recognition standards established by FIN 48. In this regard, an uncertain tax position represents the company’s expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax return, that has not been reflected in measuring income tax expense for financial reporting purposes. As a result of this review, the company adjusted the estimated value of its uncertain tax positions on January 1, 2007, by recognizing additional liabilities totaling $66 million through a charge to retained earnings, and reducing the carrying value of uncertain tax positions resulting from prior acquisitions by $63 million through a reduction of goodwill. Upon the adoption of FIN 48, the estimated value of the company’s uncertain tax positions was a liability of $514 million. If the company’s positions are sustained by the taxing authority in favor of the company, approximately $331 million would be treated as a reduction of goodwill, and the balance of $183 million would reduce the company’s effective tax rate. The company does not expect any material changes to the estimated amount of the liability associated with its uncertain tax positions within the next twelve months.

 

The company recognizes accrued interest and penalties related to uncertain tax positions in federal and foreign income tax expense. As of January 1, 2007, the company had accrued approximately $55 million for the payment of tax-related interest and penalties.

 

The company files income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. The IRS is currently examining the company’s U.S. income tax returns for 1999 – 2006, including pre-

NORTHROP GRUMMAN CORPORATION

 

acquisition activities of acquired companies. In addition, open tax years related to state and foreign jurisdictions remain subject to examination but are not considered material.

 

During the nine months ended September 30, 2007, the company’s liability for uncertain tax positions decreased $57 million primarily due to a partial settlement agreement with the IRS for the tax years 2001 – 2003.

 

 

The components of accumulated other comprehensive loss were as follows: