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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

                                        (Do not check if a smaller reporting company)

 

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

 

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

 

As of July 25, 2011, 278,056,684 shares of common stock were outstanding.

 

 

NORTHROP GRUMMAN CORPORATION

 

TABLE OF CONTENTS

 

NORTHROP GRUMMAN CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

 

 

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

 

NORTHROP GRUMMAN CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
(Unaudited)

 

 

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

 

NORTHROP GRUMMAN CORPORATION

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

 

 

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

 

NORTHROP GRUMMAN CORPORATION

 

 

 

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

 

NORTHROP GRUMMAN CORPORATION

 

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

 

 

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

 

NORTHROP GRUMMAN CORPORATION

 

 

 

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

 

The accompanying unaudited condensed consolidated financial statements of the company have been prepared by management in accordance with the rules of the Securities and Exchange Commission (SEC). These statements include all adjustments of normal recurring nature considered necessary by management for a fair presentation of the condensed consolidated financial position, results of operations, and cash flows. The results reported in these financial statements are not necessarily indicative of results that may be expected for the entire year. These financial statements should be read in conjunction with the information contained in the company’s Annual Report on Form 10-K for the year ended December 31, 2010, and the audited consolidated financial statements, including the notes thereto, contained in the Form 8-K filed on June 17, 2011, which recast certain portions of the Form 10-K to reflect the spin-off of the Shipbuilding business as discontinued operations, as discussed below.

 

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 the businesses to close their books on a Friday near 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.

 

Spin-off of Shipbuilding Business – Effective as of March 31, 2011, the company completed the spin-off to its shareholders of Huntington Ingalls Industries (HII). HII will operate the business that was previously the Shipbuilding segment (Shipbuilding) of the company prior to the spin-off. The spin-off was the culmination of the company’s decision to explore strategic alternatives for Shipbuilding as it was determined to be in the best interests of shareholders, customers, and employees by allowing both the company and Shipbuilding to pursue more effectively their respective opportunities to maximize value. As a result of the spin-off, assets, liabilities and results of operations for the former Shipbuilding segment have been reclassified as discontinued operations for all periods presented. See Note 5 for further information.

 

Accounting Estimates – The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). The preparation thereof requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of 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.

 

Accumulated Other Comprehensive Loss – The components of accumulated other comprehensive loss are as follows:

 

 

NORTHROP GRUMMAN CORPORATION

 

 

The changes in the unamortized benefit plan costs, net of tax, were $35 million and $79 million for the six months ended June 30, 2011 and 2010, respectively, and are included in other comprehensive income in the condensed consolidated statements of operations. As a result of the spin-off of Shipbuilding, the company reduced accumulated other comprehensive loss by $524 million as of March 31, 2011, for the after-tax unamortized benefit plan costs related to Shipbuilding.

 

Unamortized benefit plan costs consist primarily of net after-tax actuarial loss amounts totaling $2,186 million and $2,771 million as of June 30, 2011, and December 31, 2010, respectively. Net actuarial gains or losses principally arise from gains or losses on plan assets due to variations in the fair market value of the underlying assets and changes in the benefit obligation due to changes in actuarial assumptions. Net actuarial gains or losses are amortized to expense when they exceed ten percent of the greater of the plan assets or projected benefit obligations by benefit plan. The excess of gains or losses over the ten percent threshold are subject to amortization over ten years, which represents the approximate average future service period of employees.

 

 

Accounting standards updates not effective until after June 30, 2011, are not expected to have a material effect on the company’s consolidated financial position, results of operations or related disclosures.

 

 

Dividends on Common Stock – In April 2011, the company’s board of directors approved an increase to the quarterly common stock dividend from $0.47 per share to $0.50 per share, for shareholders of record as of May 31, 2011.

 

In May 2010, the company’s board of directors approved an increase to the quarterly common stock dividend from $0.43 per share to $0.47 per share, for shareholders of record as of June 1, 2010.

 

 

Basic Earnings Per Share – Basic earnings per share amounts from both continuing and discontinued operations are calculated by dividing the respective earnings by the weighted-average number of shares of common stock outstanding during each period.

 

Diluted Earnings Per Share – Diluted earnings per share include the dilutive effect of stock options and other stock awards granted to employees under stock-based compensation plans. The dilutive effect of these securities totaled 4.6 million shares and 5.0 million shares for the three and six months ended June 30, 2011. The dilutive effect of these securities totaled 4.2 million shares and 3.9 million shares for the three and six months ended June 30, 2010. The weighted-average diluted shares outstanding for the three and six months ended June 30, 2011, exclude anti-dilutive stock options to purchase approximately 2.0 million and 2.8 million shares, respectively, because such options have exercise prices 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 six months ended June 30, 2010, exclude anti-dilutive stock options to purchase approximately 2.6 million shares.

 

Share Repurchases – The table below summarizes the company’s share repurchases during the periods:

 

 

NORTHROP GRUMMAN CORPORATION

 

 

Under the outstanding share repurchase authorization, the company entered into an accelerated share repurchase agreement with Goldman, Sachs & Co. (Goldman Sachs) on May 2, 2011, to repurchase approximately 15.6 million shares of common stock at an initial price of $64.17 per share for a total of $1.0 billion. Under this agreement, Goldman Sachs immediately borrowed shares that were sold to and canceled by the company. Subsequently, Goldman Sachs began purchasing shares in the open market to settle its share borrowings. The cost of the company’s initial share repurchase is subject to adjustment based upon the actual cost of the shares subsequently purchased by Goldman Sachs. The price adjustment can be settled, at the company’s option, in cash or in shares of common stock.

 

As of June 30, 2011, Goldman Sachs had purchased 7.9 million shares, or 51 percent, of the shares under the agreement. Northrop Grumman’s average purchase price for these shares, per the agreement, is $65.02 net of commissions and other fees. Assuming Goldman Sachs purchases the remaining shares at a price per share equal to the average purchase price of $65.02 per share, the company would be required to pay approximately $20 million or deliver approximately 286,000 shares of common stock to Goldman Sachs to complete the transaction. The settlement amount may increase or decrease depending upon the average price paid for the shares under the program. Settlement is expected to occur in the third quarter of 2011, depending upon the timing and pace of the purchases, and would result in an adjustment to shareholders’ equity.

 

 

Spin-off of Shipbuilding Business – Effective March 31, 2011, the company completed the spin-off to its shareholders of its Shipbuilding business (HII). The company made a pro rata distribution to its shareholders of one share of HII common stock for every six shares of the company’s common stock held on the record date of March 30, 2011, or 48.8 million shares of HII common stock. There was no gain or loss recognized by the company as a result of the spin-off transaction. In connection with the spin-off, HII issued $1,200 million in senior notes and entered into a credit facility with third-party lenders that includes a $650 million revolver and a $575 million term loan. HII used a portion of the proceeds of the debt and credit facility to fund a $1,429 million cash contribution to the company.

 

Prior to the completion of the spin-off, the company and HII entered into a Separation and Distribution Agreement dated March 29, 2011, and several other agreements that will govern the post-separation relationship. These agreements generally provide that each party will be responsible for its respective assets, liabilities and obligations following the spin-off, including employee benefits, intellectual property, information technology, insurance, and tax-related assets and liabilities. The agreements also describe the company’s future commitments to provide HII with certain transition services for up to one year following the spin-off and the costs incurred for such services that will be reimbursed by HII. This transitional support will enable HII to establish its stand alone processes to assume full responsibility for various activities that were previously provided by the company and do not constitute significant continuing support of HII’s operations.

 

In connection with the spin-off, the company incurred $27 million and $11 million of non-deductible transaction costs for the six months ended June 30, 2011 and 2010, respectively, which have been included in discontinued operations. The company has incurred total transaction costs in connection with the spin-off of approximately $59 million.

 

NORTHROP GRUMMAN CORPORATION

 

National Security Technologies Deconsolidation – Effective January 1, 2011, the company reduced its participation in the National Security Technologies joint venture (NSTec). As a result of the reduced participation in the joint venture, the company no longer consolidates NSTec’s results in the company’s condensed consolidated financial statements. NSTec’s sales that were included in the company’s consolidated sales and service revenues for the six months ended June 30, 2010 were $288 million.

 

Sale of Advisory Services Division – In December 2009, the company sold its Advisory Services Division (ASD) for $1.65 billion in cash to an investor group led by General Atlantic, LLC and affiliates of Kohlberg Kravis Roberts & Co. L.P. and recognized a gain of $15 million, net of taxes. During the six months ended June 30, 2010, an additional $7 million gain, net of taxes, was recorded to reflect the purchase price adjustment called for under the sale agreement. ASD was a business unit comprised of the assets and liabilities of TASC, Inc., its wholly-owned subsidiary TASC Services Corporation, and certain contracts carved out from other Northrop Grumman businesses also in the Information Systems segment that provide systems engineering technical assistance and other analysis and advisory services.

 

Discontinued Operations – Earnings for the Shipbuilding business and gains from previous divestitures, reported as discontinued operations, are presented in the following table:

 

 

NORTHROP GRUMMAN CORPORATION

 

 

The major classes of assets and liabilities included in discontinued operations for the Shipbuilding business are presented in the following table:

 

 

 

The company is aligned into four reportable segments: Aerospace Systems, Electronic Systems, Information Systems, and Technical Services.

 

The following table presents segment sales and service revenues for the three and six months ended June 30, 2011, and 2010:

 

 

NORTHROP GRUMMAN CORPORATION

 

The following table presents segment operating income reconciled to total operating income for the three and six months ended June 30, 2011 and 2010:

 

 

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

 

Net Pension Adjustment – The 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. The increase in net pension adjustment for the three and six months ended June 30, 2011, as compared to the same periods in 2010, 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.

 

 

The company’s effective tax rates on income from continuing operations were 34.0 percent and 34.3 percent for the three and six months ended June 30, 2011, compared to (9.6) percent and 10.4 percent for the three and six months ended June 30, 2010. In the second quarter of 2010, the company received final approval from the Internal Revenue Service (IRS) and the U.S. Congressional Joint Committee on Taxation of the IRS’ examination of the company’s tax returns for the years 2004 through 2006. As a result of the settlement, the company recognized net tax benefits of approximately $298 million (of which $66 million was in cash), which were recorded as a reduction to the company’s provision for income taxes. In connection with the settlement, the company also reduced its liability for uncertain tax positions, including previously accrued interest, by $311 million. The company’s effective tax rates for the three and six months ended June 30, 2010, differ from the statutory federal rate primarily due to manufacturing deductions, research and development credits, and the tax settlement with the IRS.

 

The company recognizes accrued interest and penalties related to uncertain tax positions in federal and foreign income tax expense. The company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The IRS is currently conducting an examination of the company’s tax returns for the years

 

NORTHROP GRUMMAN CORPORATION

 

2007 through 2009. Open tax years related to state and foreign jurisdictions remain subject to examination but are not considered material.

 

 

Goodwill

The carrying amounts of goodwill at both June 30, 2011, and December 31, 2010, were as follows:

 

 

Accumulated goodwill impairment losses at June 30, 2011, and December 31, 2010, totaled $570 million at the Aerospace Systems segment.

 

Purchased Intangible Assets

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

 

 

The company’s purchased intangible assets are subject to amortization and have been amortized on a straight-line basis over an original aggregate weighted-average period of 18 years. Aggregate amortization expense for the three and six months ended June 30, 2011, was $9 million and $18 million, respectively. Aggregate amortization expense for the three and six months ended June 30, 2010, was $18 million and $36 million, respectively.

 

The table below shows expected amortization for purchased intangibles for the remainder of 2011 and for the next five years:

 

 

 

Investments in Marketable Securities – The company holds a portfolio of marketable securities, primarily consisting of equity securities that are classified as either trading or available-for-sale and can be liquidated without restriction. These assets are recorded at fair value, substantially all of which are based upon quoted market prices for identical instruments in active markets (Level 1 inputs). In June 2011, the company sold marketable securities classified as trading securities for $69 million, resulting in a $3 million realized gain on the sale of securities. As

 

NORTHROP GRUMMAN CORPORATION

 

of June 30, 2011, and December 31, 2010, there were marketable equity securities of $2 million and $68 million, respectively, included in prepaid expenses and other current assets and there were marketable equity securities of $242 million and $262 million, respectively, included in miscellaneous other assets in the condensed consolidated statements of financial position.

 

Derivative Financial Instruments and Hedging Activities – The company utilizes derivative financial instruments to manage exposure to interest rate risk and foreign currency exchange rate risk. The company does not use derivative financial instruments for trading or speculative purposes, nor does it use leveraged financial instruments. Foreign currency forward contracts are used to manage foreign currency exchange rate risk related to receipts from customers and payments to suppliers denominated in foreign currencies.

 

Derivative financial instruments are recognized as assets or liabilities in the financial statements and measured at fair value, substantially all of which are based on active or inactive markets for identical or similar instruments or model-derived valuations whose inputs are observable (Level 2 inputs). Where model-derived valuations are appropriate, the company utilizes the income approach to determine fair value and uses the applicable London Interbank Offered Rate (LIBOR) swap rate as the discount rate. Changes in the fair value of derivative financial instruments that qualify and are designated as fair value hedges are recorded in earnings from continuing operations, while the effective portion of the changes in the fair value of derivative financial instruments that qualify and are designated as effective cash flow hedges are recorded in other comprehensive income. Credit risk related to derivative financial instruments is considered minimal and is managed by requiring high credit standards for counterparties and through periodic settlements of positions.

 

For derivative financial instruments not designated as hedging instruments, as well as the ineffective portion of cash flow hedges, the gains or losses resulting from changes in the fair value are reported in Other, net in the condensed consolidated statements of operations. Unrealized gains or losses on the effective cash flow hedges are reclassified from other comprehensive income to earnings from continuing operations upon the settlement of the underlying transactions.

 

As of June 30, 2011, there were no outstanding interest rate swaps. Foreign currency purchase and sale forward contract agreements with notional values of $44 million and $124 million, respectively, were designated for hedge accounting treatment. The remaining notional values outstanding at June 30, 2011, under foreign currency purchase and sale forward contracts of $7 million and $93 million, respectively, were not designated for hedge accounting treatment.

 

As of December 31, 2010, an interest rate swap with a notional value of $200 million and foreign currency purchase and sale forward contract agreements with notional values of $40 million and $86 million, respectively, were designated for hedge accounting treatment. The remaining notional values outstanding at December 31, 2010, under foreign currency purchase and sale forward contracts of $8 million and $75 million, respectively, were not designated for hedge accounting treatment.

 

The derivative fair values and related unrealized gains and losses at June 30, 2011, and December 31, 2010, were not material.

 

There were no material transfers of financial instruments between the three levels of fair value hierarchy during the six months ended June 30, 2011, and the year ended December 31, 2010.

 

Cash Surrender Value of Life Insurance Policies – The company maintains whole life insurance policies on a group of executives, which are recorded at their cash surrender value as determined by the insurance carrier. Additionally, the company has split-dollar life insurance policies on former officers and executives from acquired businesses, which are recorded at the lesser of their cash surrender value or premiums paid. The policies are utilized as a partial funding source for deferred compensation and other non-qualified employee retirement plans. As of June 30, 2011, and December 31, 2010, the carrying values associated with these policies were $263 million and $257 million, respectively, which were included in miscellaneous other assets in the condensed consolidated statements of financial position.

 

NORTHROP GRUMMAN CORPORATION

 

Long-Term Debt – As of June 30, 2011, and December 31, 2010, the carrying values of long-term debt were $4.0 billion and $4.7 billion, respectively, and the related estimated fair values were $4.4 billion and $5.1 billion, respectively. The fair value of long-term debt is calculated based on interest rates available for debt with terms and maturities similar to the company’s existing debt arrangements. In February 2011, the company repaid notes with a face value of $750 million and an interest rate of 7.125% upon their maturity.

 

The carrying amounts of all other financial instruments not discussed above approximate fair value due to their short-term nature.

 

 

Spin-Off of Shipbuilding Business – As provided in the Separation and Distribution Agreement with HII described in Note 5, HII generally has responsibility for investigations, claims and litigation matters related to the Shipbuilding business. The company has therefore excluded from this report certain previously disclosed Shipbuilding-related investigations, claims and litigation matters that are the responsibility of HII. The company does not believe these HII matters are likely to have a material adverse effect on the company’s consolidated financial position, results of operations, or cash flows.

 

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, compensatory or treble damages or non-monetary relief. U.S. Government regulations provide that certain allegations 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 a division or subdivision. Suspension or debarment could have a material adverse effect on the company because of its reliance on government contracts and authorizations.

 

In August 2008, the company disclosed to the Antitrust Division of the Department of Justice possible violations of federal antitrust laws in connection with the bidding process for certain maintenance contracts at a military installation in California. In February 2009, the company and the Department of Justice signed an agreement admitting the company into the Corporate Leniency Program. As a result of the company’s acceptance into the program, the company will be exempt from federal criminal prosecution and criminal fines relating to the matters the company reported to the Department of Justice if the company complies with certain conditions, including its continued cooperation with the U.S. Government’s investigation and its agreement to make restitution if the government was harmed by any such violations. In July 2011, the Department of Justice informed the company that the Department had closed its criminal investigation without further action. Based upon the information available to the company to date, the company does not believe that the outcome of this matter is likely to 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.

 

The company is one of several defendants in litigation brought by the Orange County Water District in Orange County Superior Court in California on December 17, 2004, for alleged contribution to volatile organic chemical contamination of the County’s shallow groundwater. The lawsuit includes counts against the defendants for violation of the Orange County Water District Act, the California Super Fund Act, negligence, nuisance, trespass and declaratory relief. Among other things, the lawsuit seeks unspecified damages for the cost of remediation, payment of attorney fees and costs, and punitive damages. Trial is scheduled to begin on February 10, 2012.

 

On March 27, 2007, the U.S. District Court for the Central District of California consolidated two Employee Retirement Income Security Act (ERISA) lawsuits that had been separately filed on September 28, 2006, and January 3, 2007, into In Re Northrop Grumman Corporation ERISA Litigation. The plaintiffs filed a

 

NORTHROP GRUMMAN CORPORATION

 

consolidated Amended Complaint on September 15, 2010, alleging breaches of fiduciary duties by the Administrative Committees and the Investment Committees (as well as certain individuals who served on or supported those Committees) for two 401(k) Plans sponsored by Northrop Grumman Corporation. The company itself is not a defendant in the lawsuit. The plaintiffs claim that these alleged breaches of fiduciary duties caused the Plans to incur excessive administrative and investment fees and expenses to the detriment of the Plans’ participants. On August 6, 2007, the District Court denied plaintiffs’ motion for class certification, and the plaintiffs appealed the District Court’s decision on class certification to the U.S. Court of Appeals for the Ninth Circuit. On September 8, 2009, the Ninth Circuit vacated the Order denying class certification and remanded the issue to the District Court for further consideration. As required by the Ninth Circuit’s Order, the case was also reassigned to a different judge. By order dated March 29, 2011, the District Court granted the plaintiffs’ motion for class certification. The District Court held a hearing on May 16, 2011 on various cross motions for summary judgment. The supplemental briefing requested by the District Court has been filed and the motions stand submitted. No trial date has been set. Based upon the information available to the company to date, the company believes that it has substantive defenses to any potential claims but can give no assurance that the company will prevail in this litigation.

 

On June 22, 2007, a putative class action was filed against the Northrop Grumman Pension Plan and the Northrop Grumman Retirement Plan B and their corresponding administrative committees, styled as Skinner et al. v. Northrop Grumman Pension Plan, etc., et al., in the U.S. District Court for the Central District of California. The putative class representatives alleged violations of ERISA and breaches of fiduciary duty concerning a 2003 modification to the Northrop Grumman Retirement Plan B. The modification relates to the employer-funded portion of the pension benefit available during a five-year transition period that ended on June 30, 2008. The plaintiffs dismissed the Northrop Grumman Pension Plan, and in 2008, the District Court granted summary judgment in favor of all remaining defendants on all claims. The plaintiffs appealed, and in May 2009, the U.S. Court of Appeals for the Ninth Circuit reversed the decision of the District Court and remanded the matter back to the District Court for further proceedings, finding that there was ambiguity in a 1998 summary plan description related to the employer-funded component of the pension benefit. After the remand, the plaintiffs filed a motion to certify a class. The parties also filed cross-motions for summary judgment. On January 26, 2010, the District Court granted summary judgment in favor of the Plan and denied plaintiffs’ motion for summary judgment. The District Court also denied plaintiffs’ motion for class certification and struck the trial date of March 23, 2010, as unnecessary given the District Court’s grant of summary judgment for the Plan. Plaintiffs appealed the District Court’s order to the Ninth Circuit.

 

Based upon the information available to the company to date, the company does not believe that the resolution of any of the specific litigation matters listed above is likely to have a material adverse effect on its consolidated financial position, results of operations or cash flows.

 

In addition to the matters discussed above, the company is a party to various investigations, lawsuits, claims and other legal proceedings that arise in the ordinary course of our business. Based on information available to the company, the company does not believe at this time that any of such additional matters will individually, or in the aggregate, have a material adverse effect on its financial position, results of operations or cash flows.

 

 

Contract Performance Contingencies – Contract profit margins may include estimates of revenues not contractually agreed to between the customer and the company for matters such as settlements in the process of negotiation, contract changes, 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 June 30, 2011, the recognized amounts related to claims and requests for equitable adjustment are not material individually or in the aggregate.

 

NORTHROP GRUMMAN CORPORATION

 

Guarantees of Subsidiary Performance Obligations – From time to time in the ordinary course of business, the company guarantees performance obligations of its subsidiaries under certain contracts. In addition, the company’s subsidiaries may enter into joint ventures, teaming and other business arrangements (collectively, Business Arrangements) to support the company’s products and services in domestic and international markets. The company generally strives to limit its exposure under these arrangements to its subsidiary’s investment in the Business Arrangements, or to the extent of such subsidiary’s obligations under the applicable contract. In some cases, however, the company may be required to guarantee performance by the Business Arrangements and, in such cases, the company generally obtains cross-indemnification from the other members of the Business Arrangements. At June 30, 2011, the company is not aware of any existing event of default that would require it to satisfy any of these guarantees.

 

Environmental Matters – 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. These accruals do not include any litigation costs or potential liabilities to third parties related to environmental matters, nor do they include amounts recorded as asset retirement obligations. To assess the potential impact on the company’s financial statements, management estimates the range of 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 the range of reasonably possible future costs for environmental remediation sites is $299 million to $730 million. As of June 30, 2011, amounts accrued for probable environmental remediation costs are $328 million, of which $120 million is accrued in other current liabilities and $208 million is accrued in other long-term liabilities in the condensed consolidated statements of financial position. A portion of the environmental remediation costs is expected to be recoverable through overhead charges on government contracts and, accordingly, such amounts are deferred in inventoried costs (current portion) and miscellaneous other assets (non-current portion) in the condensed consolidated statements of financial position. 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, changes to the determination of legally responsible parties, 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. In addition, there are some potential remediation sites where the costs of remediation cannot be reasonably estimated. 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.

 

Financial Arrangements – In the ordinary course of business, the company uses standby letters of credit and guarantees issued by commercial banks and surety bonds issued principally by insurance companies to guarantee the performance on certain contracts. At June 30, 2011, there were $152 million of stand-by letters of credit, $197 million of bank guarantees, and $140 million of surety bonds outstanding.

 

Indemnifications – The company has retained certain warranty, environmental, income tax, and other potential liabilities in connection with certain of its divestitures. 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.

 

U.S. Government Cost Claims – From time to time, the company is advised of claims and penalties concerning certain potential disallowed costs. When such findings are presented, the company and the U.S. Government representatives engage in discussions to enable the company to evaluate the merits of these claims, as well as to assess the amounts being claimed. Where appropriate, provisions are made to reflect the company’s expected exposure to the matters raised by the U.S. Government representatives and such provisions are reviewed on a

 

NORTHROP GRUMMAN CORPORATION

 

quarterly basis for sufficiency based on the most recent information available. The company believes 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.

 

Operating Leases – Rental expense for operating leases, excluding discontinued operations, for the three and six months ended June 30, 2011, was $110 million and $215 million, respectively, and was $118 million and $236 million for the three and six months ended June 30, 2010, respectively. These amounts are net of immaterial amounts of sublease rental income.

 

Related Party Transactions – For all periods presented, the company had no material related party transactions.

 

Spin-off of Shipbuilding Business – Under the Separation and Distribution Agreement with HII described in Note 5, from and after the spin-off transaction, HII assumed responsibility for certain commitments and contingencies related to the Shipbuilding business and agreed to indemnify the company for losses related to these commitments and contingencies. The company has therefore excluded from this report previously disclosed Shipbuilding-related commitments and contingencies now assumed by HII.

 

A subsidiary of the company has guaranteed HII’s outstanding $84 million Economic Development Revenue Bonds (Ingalls Shipbuilding, Inc. Project), Taxable Series 1999A. The immaterial fair value of this guarantee was recorded in other long-term liabilities. In addition, HII has assumed the responsibility for the payment and performance of all outstanding indebtedness, obligations and liabilities of the company under this guarantee, and has agreed to indemnify the company against all liabilities that may be incurred in connection with this guarantee.

 

 

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

 

 

Employer Contributions – The company’s required minimum funding in 2011 for its pension plans and its medical and life benefit plans are approximately $59 million and $124 million, respectively. For the six months ended June 30, 2011, contributions of $550 million have been made to the company’s pension plans, including voluntary pension contribution totaling $500 million, and $40 million have been made to the company’s post-retirement medical and life benefit plans.

 

NORTHROP GRUMMAN CORPORATION

 

Defined Contribution Plans – The company also sponsors 401(k) defined contribution plans in which most employees are eligible to participate, including certain bargaining unit employees. Company contributions for most plans are based on a cash-matching of employee contributions up to 4 percent of compensation. In addition to the 401(k) defined contribution benefit plan, non-represented employees hired after June 30, 2008, are eligible to participate in a defined contribution program in lieu of a defined benefit pension plan.

 

Spin-off of Shipbuilding Business – As a result of the previously mentioned spin-off of HII discussed in Note 5, the company transferred certain pension and other post-retirement benefit plans related exclusively to Shipbuilding employees and the Shipbuilding portion of Northrop Grumman pension and other post-retirement benefit plans that included Shipbuilding employees. A re-measurement of plan assets and liabilities was performed for those plans that included both Shipbuilding and Northrop Grumman employees as of March 31, 2011, the effective date of the spin-off. The effect of this re-measurement on the company’s consolidated financial position, results of operations and cash flows was not material.

 

 

On May 18, 2011, the shareholders of the company approved the company’s 2011 Long Term Incentive Stock Plan (2011 Plan), which replaced the expired 2001 Long-Term Incentive Stock Plan (2001 Plan). At June 30, 2011, Northrop Grumman had stock-based compensation awards outstanding under the 2001 Plan, which is applicable to employees, as well as under the 1993 Stock Plan for Non-Employee Directors and 1995 Stock Plan for Non-Employee Directors, as amended (Directors Plans). At June 30, 2011, no stock-based compensation awards had yet been issued under the new 2011 Plan. Each of these plans was approved by the company’s shareholders. In addition, as a result of prior acquisitions there are other stock-based compensation awards outstanding. Share-based awards authorized under these employee plans include stock options, stock appreciation rights, stock bonuses, restricted stock, restricted stock units, performance shares and similar rights to purchase or acquire shares.

 

Under the 2011 Plan, the company is authorized to issue or transfer shares of common stock pursuant to any of the types of awards mentioned above. At June 30, 2011, the aggregate number of shares that may be issued or transferred pursuant to awards under the 2011 Plan is 45.6 million shares, including 6.5 million shares from the 2001 Plan that were previously authorized and available to be issued at the date the 2001 Plan expired. In addition, in the event that outstanding awards under the 2001 plan expire or terminate without being exercised or paid, as the case may be, such shares (the Forfeited Shares) will become available for award under the 2011 Plan. Shares issued under the 2011 Plan other than for stock options, stock appreciation rights and the Forfeited Shares will be counted against the 2011 Plan’s aggregate share limit as 4.5 shares for every one share actually issued in connection with the award; any shares issued for stock options, stock appreciation rights and the Forfeited Shares will be counted against the remaining shares on a one for one basis. The 2011 Plan will also continue to provide equity-based award grants to non-employee directors once the existing share limits of the Directors Plans have been reached.

 

Shipbuilding Spin-off Adjustments – As a result of the spin-off of Shipbuilding, effective March 31, 2011, all outstanding stock-based compensation awards related to HII employees and retirees were assumed by HII. Also effective with the spin-off, the share amounts for all remaining Northrop Grumman outstanding stock options and stock awards, and the strike price for stock options were adjusted to maintain the aggregate intrinsic value of the grants at the date of the spin-off pursuant to the terms of the company’s applicable stock-based compensation plans. Taking into account the change in the value of the company’s common stock as a result of the distribution of the HII shares to the company’s shareholders, the conversion ratio for the stock options and stock awards was 1.09. For stock options, the net effect of these adjustments resulted in an increase to the stock options outstanding due to the limited number of stock options applicable to and assumed by HII for Shipbuilding employees. For stock awards, the net effect was a decrease in stock awards outstanding as the number of shares assumed by HII for Shipbuilding employees exceeded the impact of the adjustment to the remaining Northrop Grumman employees. The Shipbuilding spin-off adjustments are reflected in the stock option and stock award tables below.

 

NORTHROP GRUMMAN CORPORATION

 

Compensation Expense

Total pre-tax stock-based compensation expense for the six months ended June 30, 2011, and 2010, was $64 million and $69 million, respectively, of which $7 million and $18 million related to stock options and $57 million and $51 million related to stock awards, respectively. Tax benefits recognized in the condensed consolidated statements of operations for stock-based compensation during the six months ended June 30, 2011, and 2010, were $26 million and $27 million, respectively. In addition, the company realized tax benefits of $15 million and $11 million from the exercise of stock options and $32 million and $34 million from the issuance of stock awards in the six months ended June 30, 2011, and 2010, respectively. As a result of the spin-off of HII described in Note 5, stock-based compensation for HII employees of $3 million and $7 million has been recorded in discontinued operations for the six months ended June 30, 2011 and 2010, respectively.

 

At June 30, 2011, there was $216 million of unrecognized compensation expense related to unvested awards granted under the company’s stock-based compensation plans, of which $20 million relate to stock options and $196 million relate to stock awards. These amounts are expected to be charged to expense over a weighted-average period of 1.5 years.

 

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 dividend yield represents the current annual dividend yield at the time stock options are awarded. 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 future forfeitures. The expected term of awards 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 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 three to four years.

 

The significant weighted-average assumptions relating to the valuation of the company’s stock options granted during the six months ended June 30, 2011, and 2010, were as follows:

 

 

The company grants stock options primarily to executives, and the expected term of six years is based on these employees’ exercise behavior. In 2009, the company granted stock options to non-executives and assigned an expected term of five years for valuing these stock options. The company believes that this stratification of expected terms best represents future expected exercise behavior between the two employee groups. The shorter expected life of non-executive employee stock options had an insignificant effect on the weighted average expected option life for the six months ended June 30, 2011, and 2010.

 

Using the Black-Scholes option pricing model, the weighted-average grant date fair value of stock options granted during the six months ended June 30, 2011, and 2010, was $14 and $11 per share, respectively.

 

NORTHROP GRUMMAN CORPORATION

 

 

Stock option activity for the six months ended June 30, 2011, was as follows:

 

 

The total intrinsic value of stock options exercised during the six months ended June 30, 2011, and 2010, was $38 million and $28 million, respectively. Intrinsic value is measured as the excess of the fair market value at the date of exercise (for stock options exercised) or at June 30, 2011 (for outstanding options), over 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, generally three years. The fair value of performance-based 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 for performance-based stock awards, the amount of shares ultimately expected to vest is estimated at each reporting date based on management’s expectations regarding the relevant performance criteria. The fair value of market-based stock awards is determined at the grant date using a Monte Carlo simulation model.

 

Stock award activity for the six months ended June 30, 2011, was as follows:

 

 

There were 2.2 million stock awards granted in the six months ended June 30, 2010, with a weighted-average grant date fair value of $60 per share. During the six months ended June 30, 2011 and 2010, the company issued 1.4 million and 1.3 million shares, respectively, to employees in settlement of prior year stock awards that became fully vested, which had total fair values at issuance of $87 million and $76 million, respectively, and grant date fair values of $101 million and $91 million, respectively. The differences between the fair values at issuance and the grant date fair values reflect the effects of performance adjustments (described above) and changes in the fair market value of the company’s common stock.

 

NORTHROP GRUMMAN CORPORATION

 

 

To the Board of Directors and Shareholders of

Northrop Grumman Corporation

Los Angeles, California

 

We have reviewed the accompanying condensed consolidated statement of financial position of Northrop Grumman Corporation and subsidiaries as of June 30, 2011, and the related condensed consolidated statements of operations for the three-month and six-month periods ended June 30, 2011 and 2010, and of cash flows and of changes in shareholders’ equity for the six-month periods ended June 30, 2011 and 2010. These interim financial statements are the responsibility of the Corporation’s management.

 

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

 

Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

 

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial position of Northrop Grumman Corporation and subsidiaries as of December 31, 2010, and the related consolidated statements of operations, cash flows and changes in shareholders’ equity for the year then ended (not presented herein); and in our report dated February 8, 2011 (June 16, 2011, as to the reclassification of the Shipbuilding segment as discontinued operations as described in Note 1), we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated statement of financial position as of December 31, 2010, is fairly stated, in all material respects, in relation to the consolidated statement of financial position from which it has been derived.

 

 

NORTHROP GRUMMAN CORPORATION

 

 

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

 

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:

 

 

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.

 

NORTHROP GRUMMAN CORPORATION

 

 

Selected financial highlights are presented in the table below:

 

 

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:

 

 

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

 

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: