UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarterly Period Ended June 30, 2003
or
For the transition period from to
Commission File Number: 1-16411
NORTHROP GRUMMAN CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
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 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 an accelerated filer (as defined in Exchange Act Rule 12b-2).
APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the latest practicable date.
As of July 30, 2003
Common stock outstanding
Preferred stock outstanding
NORTHROP GRUMMAN CORPORATION AND SUBSIDIARIES
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONSOLIDATED CONDENSED STATEMENTS OF FINANCIAL POSITION
June 30,
2003
December 31,
2002
Assets:
Cash and cash equivalents
Accounts receivable, net of progress payments of $19,133 in 2003 and $16,152 in 2002
Inventoried costs, net of progress payments of $887 in 2003 and $988 in 2002
Deferred income taxes
Prepaid expenses and other current assets
Assets of businesses held for sale
Total current assets
Net property, plant and equipment
Goodwill
Other purchased intangibles, net of accumulated amortization
of $874 in 2003 and $760 in 2002
Prepaid retiree benefits cost and intangible pension asset
Notes receivable and accrued interest
Miscellaneous other assets
Total other assets
Total Assets
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Liabilities and Shareholders’ Equity:
Notes payable to banks
Current portion of long-term debt
Trade accounts payable
Accrued employees’ compensation
Advances on contracts
Contract loss provisions
Income taxes payable
Other current liabilities
Liabilities of businesses held for sale
Total current liabilities
Long-term debt
Accrued retiree benefits
Other long-term liabilities
Minority interest
Mandatorily redeemable preferred stock
Paid-in capital
Preferred stock, 10,000,000 shares authorized; 3,500,000 shares issued and outstanding, reported above
Common stock, 800,000,000 shares authorized; issued and outstanding:2003 – 182,947,091; 2002 – 182,602,390
Retained earnings
Unearned compensation
Accumulated other comprehensive loss
Total shareholders’ equity
Total Liabilities and Shareholders’ Equity
The accompanying notes are an integral part of these consolidated condensed financial statements.
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CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS
(Unaudited)
Three months ended
Six months ended
Product sales and service revenues
Cost of product sales and service revenues
Operating costs
Administrative and general expenses
Operating margin
Interest income
Interest expense
Other, net
Income from continuing operations before income taxes and cumulative effect of accounting change
Federal and foreign income taxes
Income from continuing operations before cumulative effect of accounting change
Income from discontinued operations, net of tax
Loss on disposal of discontinued operations, net of tax
Income before cumulative effect of accounting change
Cumulative effect of accounting change
Net income (loss)
Weighted average common shares outstanding, in millions
Basic earnings (loss) per common share
Continuing operations
Discontinued operations
Disposal of discontinued operations
Before cumulative effect of accounting change
Diluted earnings (loss) per share
Dividends per common share
Dividends per mandatorily redeemable preferred share
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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Paid-in Capital
At beginning of year
Stock issued in purchase of businesses
Employee stock awards and options
Retained Earnings
Cash dividends
Unearned Compensation
Amortization of unearned compensation
Accumulated Other Comprehensive Loss
Change in cumulative translation adjustment
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CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
Operating Activities
Sources of Cash—Continuing Operations
Cash received from customers
Progress payments
Other collections
Interest received
Income tax refunds received
Other cash receipts
Cash provided by operating activities
Uses of Cash—Continuing Operations
Cash paid to suppliers and employees
Interest paid
Income taxes paid
Other cash payments
Cash used in operating activities
Cash (used in) provided by continuing operations
Cash provided by discontinued operations
Net cash (used in) provided by operating activities
Investing Activities
Proceeds from sale of businesses, net of cash divested
Payment for businesses purchased, net of cash acquired
Additions to property, plant and equipment
Proceeds from sale of property, plant and equipment
Other investing activities, net
Net cash provided by (used in) investing activities
Financing Activities
Borrowings under lines of credit
Repayment of borrowings under lines of credit
Principal payments of long-term debt/capital leases
Proceeds from issuance of stock
Dividends paid
Redemption of minority interest
Net cash used in financing activities
Decrease in cash and cash equivalents
Cash and cash equivalents balance at beginning of period
Cash and cash equivalents balance at end of period
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Six months ended June 30, $ in millions
Reconciliation of Income from Continuing Operations before Cumulative
Effect of Accounting Change to Net Cash (Used in) Provided byOperating Activities:
Adjustments to reconcile to net cash (used in) provided by operating activities
Depreciation
Amortization of intangible assets
Common stock issued to employees
Gain on disposals of property, plant and equipment
Amortization of long-term debt premium
(Increase) decrease in
Accounts receivable
Inventoried costs
Increase (decrease) in
Accounts payable and accruals
Provisions for contract losses
Retiree benefits
Other noncash transactions
Noncash Investing and Financing Activities:
Conversion of debt to equity
Sale of business
Note receivable, net of discount
Investment in unconsolidated affiliate
Purchase of businesses
Fair value of assets acquired
Cash paid
Common stock issued
Liabilities assumed
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NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
Basis of Presentation
The unaudited consolidated condensed financial statements include the accounts of Northrop Grumman Corporation and its subsidiaries (the company). All material 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 results of operations, financial position and cash flows. The results reported in these 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 and Independent Auditors’ Report contained in the company’s 2002 Annual Report.
Financial Statement Reclassification
Certain prior year amounts have been reclassified to conform to the 2003 presentation.
Earnings per Share
Basic earnings per share from continuing operations before cumulative effect of accounting change are calculated by dividing income available to common shareholders from continuing operations before cumulative effect of accounting change by the weighted average number of shares of common stock outstanding during each period, after giving recognition to stock splits and stock dividends. Income available to common shareholders from continuing operations before cumulative effect of accounting change is calculated by reducing income from continuing operations before cumulative effect of accounting change by the amount of dividends accrued on mandatorily redeemable preferred stock. Diluted earnings per share from continuing operations before cumulative effect of accounting change reflect the dilutive effect of stock options and other stock awards granted to employees under stock-based compensation plans and the dilutive effect of the equity security units as applicable. Shares issuable pursuant to mandatorily redeemable preferred stock have not been included in the diluted earnings per share calculation because their effect is currently anti-dilutive.
Basic and diluted earnings per share from continuing operations before cumulative effect of accounting change are calculated as follows:
Basic Earnings per Share
Less preferred dividends
Income available to common shareholders from continuing operations before cumulative effect of accounting change
Weighted-average common shares outstanding, in millions
Basic earnings per share from continuing operations before cumulative effect of accounting change
Diluted Earnings per Share
Dilutive effect of stock options, awards and equity security units, in millions
Weighted-average diluted shares outstanding, in millions
Diluted earnings per share from continuing operations before cumulative effect of accounting change
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Goodwill and Other Purchased Intangible Assets
The company accounts for goodwill under the impairment-only approach prescribed by Statement of Financial Accounting Standards (SFAS) No. 142 – Goodwill and Other Intangible Assets. Impairment tests are performed at least annually and more often as circumstances require. Goodwill and other purchased intangible assets balances are included in the identifiable assets of the segment to which they have been assigned. Any goodwill impairment, as well as the amortization of other purchased intangible assets, is charged against the respective segment’s operating margin. The annual impairment test for all sectors except Mission Systems and Space Technology was performed as of April 30, 2003, with no indication of impairment. Mission Systems and Space Technology will be tested in the second half of the year.
The changes in the carrying amount of goodwill for the six months ended June 30, 2003, are as follows:
$ in millions
Balance as of
December 31, 2002
acquired
Fair value
adjustments
to netassets
June 30, 2003
Electronic Systems
Ships
Information Technology
Mission Systems
Integrated Systems
Space Technology
Total
In connection with the acquisition of TRW Inc. (TRW), the company has allocated $416 million of the purchase price as purchased intangible assets with a weighted average life of 8 years. See the “Acquisitions” footnote contained herein for additional information. The table below summarizes the company’s aggregate purchased intangible assets as of June 30, 2003, and December 31, 2002.
Accumulated
Amortization
Contract and program intangibles
Other purchased intangibles
All of 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 22 years. Aggregate amortization expense for the three months and six months ended June 30, 2003, was $57 million and $114 million, respectively.
The table below shows expected amortization for the remainder of 2003 and for the next five years:
Year Ended December 31,
2003 (July 1 to December 31)
2004
2005
2006
2007
2008
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Discontinued Operations
The company’s Condensed Consolidated Financial Statements and related footnote disclosures reflect the Auto and Component Technologies businesses as discontinued operations, net of applicable income taxes, for all periods presented in accordance with SFAS No. 144 – Accounting for the Impairment or Disposal of Long-Lived Assets. As such, discontinued operations includes the January and February 2003 results of TRW Automotive (Auto), the sale of which was completed February 28, 2003, and the results of the company’s remaining Component Technologies businesses. The assets and liabilities of these businesses have been reclassified as held for sale.
Proceeds received in the first quarter of 2003 from the sale of Auto included $3.3 billion in cash, a $600 million face value payment-in-kind note, valued at $455 million, and a 19.6 percent investment in the new enterprise, valued at $170 million. The cash received was adjusted from the sale agreement amount by cash sold with the business, preliminary purchase price adjustments, and an asset retained. The payment-in-kind note matures in 2018 and bears interest at an effective yield of 11.7 percent per annum. The acquirer also assumed debt of approximately $200 million. Final valuation of the Auto transaction will occur upon settlement of purchase price adjustments, expected to be completed in the second half of 2003, and may result in additional adjustments. The company has retained certain liabilities associated with the Auto business as well as the Aeronautical Systems business that TRW divested in 2002.
In the second quarter of 2003, the company entered into an agreement with COB Support Acquisition Inc., an indirect wholly-owned subsidiary of Cobham plc, to sell the Life Support business, one of the discontinued Component Technologies businesses. The transaction is expected to close in the second half of 2003.
Operating results of the discontinued businesses for the three months and six months ended June 30, 2003, and 2002, respectively, are as follows:
Sales
Income from discontinued operations
Income tax expense
Loss on disposal of discontinued operations
Income tax benefit
The major classes of assets and liabilities for the discontinued businesses at June 30, 2003, and December 31, 2002, were as follows:
Current assets
Accounts payable and other current liabilities
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Acquisitions
In December 2002, the company purchased 100 percent of the common stock of TRW. TRW’s defense business units are operated as two separate sectors, Mission Systems and Space Technology. The TRW acquisition is accounted for using the purchase method of accounting. Under the purchase method of accounting, the purchase price is allocated to the underlying tangible and intangible assets acquired and liabilities assumed based on their respective fair market values, with the excess recorded as goodwill. The financial statements and the information from which they were derived reflect preliminary estimates of the fair market value of the assets acquired and liabilities assumed and the related allocations of purchase price and preliminary estimates of adjustments necessary to conform TRW to the company’s accounting policies. The company is currently reviewing preliminary accounting conformance adjustments and preliminary estimates of the fair market value of assets acquired and liabilities assumed, including valuations associated with certain contracts, debt, environmental and other legal contingencies, restructuring activities, warranty liabilities, income taxes, insurance liabilities, property, plant, and equipment, retiree benefits assets and liabilities, and any purchase price adjustments and retained liabilities associated with the Auto and Aeronautical Systems divestitures. The final determination of the fair market value of assets acquired and liabilities assumed and final allocation of the purchase price may differ significantly from the amounts included in the financial statements contained in this Form 10-Q. Adjustments to the purchase price allocations of TRW are expected to be finalized by the fourth quarter of 2003 and will be reflected in future filings. There can be no assurance that such adjustments will not be material.
Segment Information
The table below shows segment operating information for the three months and six months ended June 30, 2003, and 2002, respectively.
Net Sales
Intersegment eliminations
Total Net Sales
Operating Margin
Total Segment Operating Margin
Adjustments to reconcile to total operating margin:
Unallocated expenses
Pension (expense) income
Reversal of CAS pension expense included above
Reversal of royalty income included above
Total Operating Margin
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Pension expense is included in determining the sectors’ operating margin to the extent that the cost is currently recognized under government Cost Accounting Standards (CAS). In order to reconcile from segment operating margin to total company operating margin, these amounts are reported under the caption “Reversal of CAS pension expense included above.” Total pension income or expense determined under Generally Accepted Accounting Principles (GAAP) is reported separately as a reconciling item under the caption “Pension (expense) income.” The reconciling item captioned “Unallocated expenses” includes the portion of corporate expenses, state tax provisions and other retiree benefit expenses that are not allocated to the sectors.
Long-Term Debt
In March 2003, the company’s wholly owned subsidiary, Northrop Grumman Space & Mission Systems Corp. (formerly TRW Inc.), commenced offers to purchase any or all of certain designated outstanding Northrop Grumman Space & Mission Systems Corp. debt securities in a debt reduction plan substantially completed in the second quarter of 2003. In the first phase, approximately $2.4 billion in aggregate principal amount of outstanding debt securities were tendered and accepted for purchase, for a total purchase price of approximately $2.9 billion (including accrued and unpaid interest on the securities). In the second phase, the company purchased on the open market approximately $642 million in aggregate principal amount for a total purchase price of $777 million (including accrued and unpaid interest on the securities). Cash proceeds from the sale of Auto were used to complete these transactions, which contributed to the reduction of long-term debt to $6.4 billion at June 30, 2003, from the $9.4 billion reported at December 31, 2002.
Long-term debt at June 30, 2003, and December 31, 2002, consisted of the following:
Notes and debentures due 2003 to 2036, rates from 6.05% to 12.36%
Equity security unit notes due 2006, 7.25%
Revolving credit facility, weighted average interest rate of 2.24%
Other indebtedness due 2004 to 2024, rates from 7.0% to 8.5%
Less current portion
Litigation, Commitments and Contingencies
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 does not believe that the resolution of any of these proceedings will have a material adverse affect upon its operations or financial condition.
U.S. ex rel. Bagley v. TRW Inc., previously reported in the company’s public filings, has been settled for $111.2 million. The settlement payment was made in July 2003. The company reviewed this case in preparation for the acquisition of TRW Inc. and it is being accounted for as part of the acquisition. As such, the settlement did not have an effect on the company’s results of operations. The relator’s claim for attorneys’ fees should be resolved in the third quarter and the entire action dismissed with prejudice.
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Stock-Based Compensation
The company applies Accounting Principles Board Opinion 25 – Accounting for Stock Issued to Employees and related Interpretations in accounting for awards made under the company’s stock-based compensation plans. When stock options are exercised, the amount of the cash proceeds to the company is recorded as an increase to paid-in capital. Compensation expense for restricted performance stock rights is estimated and accrued over the vesting period.
Had compensation expense been determined based on the fair value at the grant dates for stock option awards, consistent with the method of SFAS No. 123– Accounting for Stock Based Compensation, net income (loss), basic earnings (loss) per share, and diluted earnings (loss) per share would have been as shown in the table below.
Net income (loss) as reported
Stock based compensation, net of tax, included in net income as reported
Stock based compensation, net of tax, that would have been included in net income, if the fair value method had been applied to all awards
Pro-forma net income (loss) using the fair value method
Basic Earnings (Loss) Per Share
As reported
Pro forma
Diluted Earnings (Loss) Per Share
These amounts were determined using weighted-average per share fair values for market options granted in 2003 and 2002 of $30 and $28, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model based on an expected life of six years and for the three months and six months ended June 30, 2003 and 2002, respectively, the following additional assumptions: dividend yield, 1.8 percent and 1.6 percent; expected volatility, 36 percent and 35 percent; and risk-free interest rate, 3.2 percent and 3.6 percent.
Minority Interest
As of December 31, 2002, TRW Automotive Inc. (TAI) had outstanding 100,000 shares of Series A Convertible Preferred Stock (TAI Series A) and 30,000 shares of Series B Preferred Stock (TAI Series B), of which 14,000 shares were owned by Northrop Grumman. All of the outstanding TAI Series A and TAI Series B shares were redeemed in the second quarter of 2003 for $117 million.
New Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board issued SFAS No. 150 – Accounting for Certain Financial Instruments with Characteristics of both Liability and Equity. It requires an issuer to classify certain financial instruments as liabilities and assets in defined circumstances. This statement becomes effective for financial statements issued for interim periods beginning after June 15, 2003. Management is currently evaluating the effect that adoption of this standard will have on the company’s results of operations and financial position.
In April 2003, the Financial Accounting Standards Board issued SFAS No. 149 – Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which clarifies and amends certain definitions and characteristics of derivative instruments contained in SFAS No. 133 – Accounting for Derivative Instruments and Hedging Activities, FASB Interpretation No. 45: Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect
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Guarantees of Indebtedness of Others and other existing pronouncements. Adoption of this statement will not have an effect on the company’s financial position, results of operations or cash flows.
In January 2003, the Emerging Issues Task Force (EITF) published EITF Issue 00-21 – Revenue Arrangements with Multiple Deliverables (EITF 00-21), which provides guidance on how to recognize revenue in certain arrangements with multiple deliverables. This issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Management is currently evaluating the effect that adoption of EITF 00-21 will have on the company’s results of operations and financial position.
In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46 – Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. This interpretation explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity. This interpretation requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among the parties involved. Management is currently evaluating the effect that adoption of this standard will have on the company’s results of operations and financial position.
In November 2002, the Financial Accounting Standards Board issued FASB Interpretation No. 45 – Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken by issuing the guarantee. Application of this interpretation did not have a significant effect on the company’s financial position, results of operations or cash flows.
In June 2002, the Financial Accounting Standards Board issued SFAS No. 146 – Accounting for Costs Associated with Exit or Disposal Activities,which requires a liability for a cost associated with an exit or disposal activity to be recognized and measured at its fair value in the period in which the liability is incurred. This statement was adopted January 1, 2003, and did not have a significant effect on the company’s financial position, results of operations or cash flows.
In August 2001, the Financial Accounting Standards Board issued SFAS No. 143 – Accounting for Asset Retirement Obligations. SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This statement becomes effective for financial statements issued for fiscal years beginning after June 15, 2002. This statement was adopted January 1, 2003, and did not have a significant effect on the company’s financial position, results of operations or cash flows.
The 2003 results include the operations of TRW Inc. (TRW), acquired in the fourth quarter of 2002. Operating results of the acquired TRW businesses are reported as the Mission Systems and Space Technology sectors of the company. This acquisition is an important component of the increase in sales, operating margin and net income for the 2003 periods compared with 2002.
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SELECTED INDUSTRY SEGMENT INFORMATION
Segments:
Contract Acquisitions
Total Contract Acquisitions
Funded Order Backlog
Total Funded Order Backlog
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Contract acquisitions increased 36 percent to $5.2 billion for the second quarter of 2003 as compared to the second quarter a year ago, and increased 30 percent to $12.3 billion in the six-month period of 2003 compared to the 2002 period. Growth in 2003 principally reflects inclusion of the two new sectors, Mission Systems for $729 million and $2 billion in the quarterly and six-month periods and Space Technology for $643 million and $1.4 billion in the quarterly and six-month periods of 2003. In last year’s first quarter, Ships reported contract acquisitions of $1.8 billion resulting from the funding of Virginia-class submarines and refueling and overhaul of the carrier USS Eisenhower. The company’s business backlog at June 30, 2003, increased to $25.9 billion from $21.7 billion reported a year earlier.
Measures of Performance
Sales for the second quarter of 2003 increased 57 percent to $6.6 billion and for the six-month period of 2003 increased 53 percent to $12.5 billion, as compared with the same periods of 2002. Sales for 2003 are expected to be between $25 billion and $26 billion. Sales by business area are outlined below. Certain prior year amounts have been reclassified to conform to the 2003 presentation.
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Aerospace Electronic Systems
C4ISR&N
Defensive Electronic Systems
Navigation Systems
Space Systems
Other
Aircraft Carriers
Surface Combatants
Amphibious and Auxiliary
Submarines
Commercial and International
Services and Other
Intrasegment Eliminations
Government Information Technology
Enterprise Information Technology
Technology Services
Commercial Information Technology
Command, Control & Intelligence
Missile Systems
Federal & Civil Information Systems
Technical Services
Air Combat Systems
Airborne Early Warning/Electronic Warfare
Airborne Ground Surveillance/Battle Management
Intelligence, Surveillance, & Reconnaissance
Satellite Communications
Civil Space
Missile Defense
Radio Systems
Technology
Total sales
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Sales at Electronic Systems sector increased 16 percent and 14 percent to $1.5 billion and $2.8 billion in the second quarter and six-month periods of 2003 as compared to the same periods of 2002. Operating margin for the second quarter increased 36 percent to $148 million as compared to the 2002 second quarter and increased 35 percent to $269 million in the 2003 six-month period in contrast to the 2002 six-month period. Second quarter and six-month 2003 results for sales and operating margin reflect the benefit of increased deliveries in Aerospace Electronic Systems on the F/A-22, Apache Longbow and F-16 programs and increased volume and improved performance on C4ISR&N programs. For 2003, Electronic Systems sales are expected to be between $5.9 billion and $6.1 billion with operating margin of nearly 10 percent of sales.
Ships, which includes the financial results of the Newport News and Ship Systems sectors, generated sales of $1.4 billion and $2.6 billion in the second quarter and six-month periods of 2003, reflecting 19 percent and 15 percent increases in contrast to the 2002 periods. Operating margin was $23 million for the second quarter and $98 million for the six-month period of 2003, compared to operating margin of $85 million and $152 million in the 2002 second quarter and year-to-date periods, respectively. The sales growth reflects increased revenue on the DDX program, included in the Surface Combatant business area, and on the LPD program, included in the Amphibious and Auxiliary business area. The second quarter 2003 results include a $68 million pre-tax charge to operating margin on the commercial Polar Tanker program. The charge includes cost growth on the third tanker due to unusual weather delays and rework. This tanker was delivered to the customer on July 21. The charge also includes increased estimates to complete the final two ships to reflect more modest improvements in labor productivity and higher overhead costs than previously expected. The fourth ship is approximately 75 percent complete and is scheduled for delivery in late 2004. The fifth and last ship is approximately 35 percent complete and is scheduled for delivery in late 2005. Operating margin for the 2003 second quarter also reflects higher purchased intangibles amortization expense at the Newport News sector as compared to the same quarter of last year. Last year’s second quarter included a reduction of purchased intangibles amortization as a result of the finalization of the useful lives of purchased intangibles. Sales in 2003 are expected to be just over $5 billion, with operating margin as a percent of sales expected to be in the mid-5 percent range.
Information Technology sector sales increased 11 percent and 14 percent to $1.2 billion and $2.2 billion in the second quarter and six-month periods of 2003 as compared to the same periods of 2002, with growth in all business areas. For the quarter and six-month periods of 2003, the sector generated increases of 63 percent and 42 percent in operating margin to $67 million and $129 million compared to the 2002 periods, reflecting increased revenues and a higher operating margin rate on Government Information Technology business. Last year’s second quarter results included a $16 million charge recorded on a contract relating to Oracle’s Enterprise Licensing Agreement with the State of California. For 2003, sales are expected to be approximately $4.7 billion with operating margin as a percent of sales of approximately 6 percent.
Mission Systems reported 2003 second quarter and six-month sales of $1.1 billion and $2 billion led by its Command, Control & Intelligence Systems and Missile Systems business areas. The segment’s 2003 second quarter and year-to-date operating margins were $74 million and $130 million, respectively. For 2003, sales are expected to be approximately $4 billion with operating margin as a percent of sales of approximately 6 percent.
Sales for Integrated Systems increased 19 percent to $1 billion in the second quarter of 2003 and increased 10 percent to $1.8 billion in the 2003 six-month period compared to the 2002 second quarter and six-month periods. Operating margin for the 2003 second quarter and six-month periods increased 23 percent and 9 percent to $123 million and $210 million, respectively from the 2002 periods. Integrated Systems results reflect increased F-35, E2C, and Global Hawk sales and operating margin, which were partially offset by lower Joint STARS volume. For 2003, sales are expected to be approximately $3.6 billion to $3.8 billion with operating margin as a percent of sales expected to be between 9 percent and 9.5 percent.
Sales for Space Technology for the 2003 second quarter and six-month periods totaled $733 million and $1.4 billion, respectively, led by revenues from its Intelligence, Surveillance & Reconnaissance and Civil Space business areas. The sector’s operating margin in the second quarter and six-months periods of 2003 were $55 million and $87 million, respectively. For 2003, sales are expected to be approximately $2.6 billion with operating margin as a percent of sales of slightly more than 6 percent.
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Operating margin included $140 million and $280 million of pension expense in the second quarter and six-month periods of 2003, compared with $22 million and $46 million of pension income reported in the 2002 periods. Pension expense for 2003 is expected to total approximately $560 million. Total pension income or expense determined under Generally Accepted Accounting Principles (GAAP) is reported separately as a reconciling item in the table “Selected Industry Segment Information” under the caption “Pension (expense) income.” Pension expense is included in determining the sectors’ operating margin to the extent that the cost is currently recognized under government Cost Accounting Standards (CAS). In the adjustments to reconcile to total company operating margin, these amounts are reported under the caption “Reversal of CAS pension expense included above” and for the year 2003 are estimated to be approximately $275 million.
The increase in interest income for the 2003 periods as compared to the 2002 periods principally reflects earnings from the note received in connection with the sale of Auto and interest earned on a tax refund received in the first quarter of 2003. Interest income for the year 2003 is expected to be approximately $55 million.
Interest expense for the second quarter and six-month periods of 2003 increased to $119 million and $263 million, respectively, from $105 million and $214 million reported in the 2002 periods principally as a result of increased debt levels arising from the acquisition of TRW, net of the effect of the company’s debt reduction plan which was substantially completed in the second quarter of 2003. Interest expense for the year 2003 is expected to be between $485 million and $490 million.
The company’s effective tax rate in the second quarter of 2003 was 31 percent compared to 30.6 percent in the 2002 period. During the first quarter of 2003, the company recorded a $26 million tax credit for additional research tax credits resulting in a 2003 six-month effective tax rate of 25.7 percent as compared to 30.8 percent in the 2002 six-month period. The effective tax rate is expected to be approximately 31 percent for the remainder of 2003, resulting in a rate of approximately 28 percent for the entire year.
Net income for the second quarter and six-month periods of 2003 was $205 million and $458 million, respectively, or $1.08 and $2.42 per diluted share, compared to income of $182 million and a loss of $101 million, or $1.53 and $(.99) per diluted share, for the same periods of 2002. Second quarter and six-months 2003 diluted earnings per share are based on weighted average diluted shares outstanding of 182.93 million and 182.81 million, respectively, as compared to 112.84 million and 112.12 million in the respective 2002 periods. Discontinued operations generated income of $2 million and income of $82 million for the second quarter and six-month periods of 2003, respectively, compared to income of $1 million and $1 million in the second quarter and first half of 2002. Results reflected in the six-month period of 2002 include a first quarter 2002 charge of $432 million for the cumulative effect of an accounting change recorded upon adoption of SFAS No. 142 – Goodwill and Other Intangible Assets.
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TRW Acquisition
The TRW acquisition is accounted for using the purchase method of accounting. Under the purchase method of accounting, the purchase price is allocated to the underlying tangible and intangible assets acquired and liabilities assumed based on their respective fair market values, with the excess recorded as goodwill. The financial statements and the information from which they were derived reflect preliminary estimates of the fair market value of the assets acquired and liabilities assumed and the related allocations of purchase price and preliminary estimates of adjustments necessary to conform TRW to the company’s accounting policies. The company is currently reviewing preliminary accounting conformance adjustments and preliminary estimates of the fair market value of assets acquired and liabilities assumed, including valuations associated with certain contracts, debt, environmental and other legal contingencies, restructuring activities, warranty liabilities, income taxes, insurance liabilities, property, plant, and equipment, retiree benefits assets and liabilities, and any purchase price adjustments and retained liabilities associated with the Auto and Aeronautical Systems divestitures. The final determination of the fair market value of assets acquired and liabilities assumed and final allocation of the purchase price may differ significantly from the amounts included in the financial statements contained in this Form 10-Q. Adjustments to the purchase price allocations of TRW are expected to be finalized by the fourth quarter of 2003 and will be reflected in future filings. There can be no assurance that such adjustments will not be material.
Liquidity and Capital Resources
In the first half of 2003, the company used cash from operations of $375 million, compared with cash generated of $473 million in the first half of 2002. At June 30, 2003, net working capital deficit was $81 million which is the result of normal fluctuations in timing of receipts and disbursements, working down advances on contracts, payments associated with acquired businesses and income tax liabilities. In 2003, cash used in operations reflects $1 billion of taxes paid upon completion of the B-2 EMD contract. The IRS is presently completing its audits of the B-2 program for the tax years ended December 31, 1997, through December 31, 2000. Upon completion of these audits, the IRS may adopt a position that the B-2 program was completed in a year prior to 2002, which would create the potential for additional interest expense. Although it is not possible to predict the outcome of the tax audits at this time, management believes that its tax accounting for the B-2 program reflects the appropriate timing of contract completion. Presently, the IRS has not commenced its audits for tax years ended December 31, 2001 or 2002.
In March 2003, the company’s wholly owned subsidiary, Northrop Grumman Space & Mission Systems Corp. (formerly TRW Inc.), commenced offers to purchase any or all of certain designated outstanding Northrop Grumman Space & Mission Systems Corp. debt securities in a debt reduction plan substantially completed in the second quarter of 2003. In the first phase, approximately $2.4 billion in aggregate principal amount of outstanding debt securities had been tendered and accepted for purchase, for a total purchase price of approximately $2.9 billion (including accrued and unpaid interest on the securities). In the second phase, the company purchased on the open market approximately $642 million in aggregate principal amount for a total purchase price of $777 million (including accrued and unpaid interest on the securities) of Northrop Grumman Space & Mission Systems Corp. debt securities. Cash proceeds from the sale of Auto were used to complete these transactions, which contributed to the reduction of long-term debt to $6.4 billion at June 30, 2003, from the $9.4 billion reported at December 31, 2002.
During the second quarter of 2003, the company redeemed all outstanding shares of TRW Automotive Inc. Series A Convertible Preferred Stock and Series B Preferred Stock for $117 million.
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For the remainder of 2003, cash generated from operations supplemented by borrowings under credit facilities are expected to be sufficient to service debt, finance capital expenditures and continue paying dividends to the company’s shareholders.
Critical Accounting Policies
The company’s financial statements are in conformity with generally accepted accounting principles. The preparation thereof requires management to make estimates and assumptions 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.
There have been no changes in the company’s critical accounting policies during the six months ended June 30, 2003.
Financial Accounting Standards
In May 2003, the Financial Accounting Standards Board issued SFAS No. 150 – Accounting for Certain Financial Instruments with Characteristics of both Liability and Equity. It requires an issuer to classify certain financial instruments as liabilities and assets in defined circumstances. This statement becomes effective for financial statements issued for interim periods beginning after June 15, 2003. Management is currently evaluating the effect that adoption of this standard will have on the company’s results of operations and financial position
In April 2003, the Financial Accounting Standards Board issued SFAS No. 149 – Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which clarifies and amends certain definitions and characteristics of derivative instruments contained in SFAS No. 133 – Accounting for Derivative Instruments and Hedging Activities, FASB Interpretation No. 45: Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others and other existing pronouncements. Adoption of this statement will not have an effect on the company’s financial position, results of operations or cash flows.
In June 2002, the Financial Accounting Standards Board issued SFAS No. 146 – Accounting for Costs Associated with Exit or Disposal Activities, which requires a liability for a cost associated with an exit or disposal activity to be recognized and measured at its fair value in the period in which the liability is incurred. This statement was adopted January 1, 2003, and did not have a significant effect on the company’s financial position, results of operations or cash flows.
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Forward-Looking Information
Certain statements and assumptions in this Management’s Discussion and Analysis and elsewhere in this Quarterly Report on Form 10-Q contain or are based on “forward-looking” information (that Northrop Grumman believes to be within the definition in the Private Securities Litigation Reform Act of 1995) and involve risks and uncertainties, and include, among others, statements in the future tense, and all statements accompanied by terms such as “project,” “expect,” “estimate,” “assume,” or variations thereof. This information reflects the company’s best estimates when made, but the company expressly disclaims any duty to update this information if new data becomes available or estimates change after the date of this Report.
Such “forward-looking” information is based on numerous assumptions and uncertainties, many of which are outside Northrop Grumman’s control. These include Northrop Grumman’s ability to successfully integrate its acquisitions, including TRW, to realize the preliminary estimates for accounting conformance and purchase accounting valuations for TRW which will be finalized in the 2003 fourth quarter and which may materially vary from these estimates, assumptions with respect to future revenues, expected program performance and cash flows, returns on pension plan assets and variability of pension actuarial and related assumptions, the outcome of litigation and appeals, environmental remediation, divestitures of businesses, successful reduction of debt, successful negotiation of contracts with labor unions, effective tax rates and timing and amounts of tax payments, and anticipated costs of capital investments, among other things. Northrop Grumman’s operations are subject to various additional risks and uncertainties resulting from its position as a supplier, either directly or as subcontractor or team member, to the U.S. Government and its agencies as well as to foreign governments and agencies; actual outcomes are dependent upon factors, including, without limitation, Northrop Grumman’s successful performance of internal plans; government customers’ budgetary constraints; customer changes in short-range and long-range plans; domestic and international competition in both the defense and commercial areas; product performance; continued development and acceptance of new products; performance issues with key suppliers and subcontractors; government import and export policies; acquisition or termination of government contracts; the outcome of political and legal processes; legal, financial, and governmental risks related to international transactions and global needs for military aircraft, military and civilian electronic systems and support, information technology, naval vessels, space systems and related technologies, as well as other economic, political and technological risks and uncertainties and other risk factors set out in Northrop Grumman’s filings from time to time with the Securities and Exchange Commission, including, without limitation, Northrop Grumman reports on Form 10-K and Form 10-Q.
Item 3. Quantitative and Qualitative Disclosures About Market Risks
The company is exposed to market risk, primarily related to interest rates and foreign currency exchange rates. Financial instruments subject to interest rate risk include fixed-rate long-term debt obligations, variable-rate short-term debt outstanding under the credit facility, short-term investments, and long-term notes receivable. At June 30, 2003, most borrowings were fixed-rate long-term debt obligations, significant portions of which are not callable until maturity. The company’s sensitivity to a 1 percent change in interest rates is tied to its $2.5 billion credit facility, which had a balance outstanding of $630 million at June 30, 2003. The estimated fluctuation in expense would be 1 percent of any outstanding balance. The company may enter into interest rate swap agreements to manage its exposure to interest rate fluctuations. At June 30, 2003, no interest rate swap agreements were in effect. The company enters into foreign currency forward contracts to manage foreign currency exchange rate risk related to receipts from customers and payments to suppliers denominated in foreign currencies. Foreign currencies are traditionally converted to U.S. dollars upon receipt to limit currency fluctuation exposures. At June 30, 2003, the amount of foreign currency forward contracts outstanding was not material. The company does not consider the
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market risk exposure relating to foreign currency exchange to be material. The company does not hold or issue derivative financial instruments for trading purposes. Standby letters of credit are used by the company to guarantee future performance on its contracts.
As disclosed in the company’s Annual Report on Form 10-K for the year ended 2002, investments in RF Micro Devices, Inc. (RFMD) and Applera Corporation-Celera Genomics Group (Celera) acquired in connection with the acquisition of TRW, and the related hedge portion of the forward share sale agreements are carried at fair market value. As of June 30, 2003, the value of the investments and the hedge were equivalent. Accordingly, no gains or losses are expected to be recorded from these agreements.
Item 4. Controls and Procedures
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INDEPENDENT ACCOUNTANTS’ REPORT
To the Board of Directors and Shareholders of
Northrop Grumman Corporation
Los Angeles, California
We have reviewed the accompanying consolidated condensed statement of financial position of Northrop Grumman Corporation and subsidiaries as of June 30, 2003, and the related consolidated condensed statements of operations for the three-month and six-month periods ended June 30, 2003 and 2002, and the related consolidated condensed statements of cash flows and changes in shareholders’ equity for the six-month periods ended June 30, 2003 and 2002. These interim financial statements are the responsibility of the Corporation’s management.
We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. 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 auditing standards generally accepted in the United States of America, 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 consolidated condensed 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 auditing standards generally accepted in the United States of America, the consolidated statement of financial position of Northrop Grumman Corporation and subsidiaries as of December 31, 2002, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated March 18, 2003, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated condensed statement of financial position as of December 31, 2002 is fairly stated, in all material respects, in relation to the consolidated statement of financial position from which it has been derived.
/s/ DELOITTE & TOUCHE LLP
July 25, 2003
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
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. 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. Based on available information, the company does not believe, but can give no assurance, that any matter resulting from a U.S. Government investigation would have a material adverse effect on its results of operations or financial condition. Matters described below include cases in which the U.S. Government is a party. The company is unable to predict whether or not adverse decisions in these matters would have a material adverse effect on the company’s financial condition.
U.S. ex rel. Bagley v. TRW Inc., previously reported in the company’s public filings, has been settled for $111.2 million. The settlement payment was made in July 2003. The company reviewed this case in preparation for the acquisition of TRW Inc. and it is being accounted for as part of the acquisition. As such, the settlement did not have an effect on the company’s results of operations. The relator’s claim for attorneys’ fees should be resolved in the third quarter and the entire action dismissed with prejudice. The action involved allegations that TRW misclassified various costs and improperly charged those costs to certain of its federal contracts, that the United States had incurred substantial damages, and that TRW was liable for approximately $56 million in single damages, subject to trebling, plus penalties, post-judgment interest, costs (including attorneys’ fees) and “all other proper relief.”
As previously reported, on February 3, 2003, the Department of Justice filed a civil False Claims Act case against Newport News Shipbuilding, Inc. in the United States District Court for the Eastern District of Virginia in U.S. v. Newport News Shipbuilding, Inc. The government seeks single damages in an amount in excess of $72 million, plus penalties, costs and interest. Damages may be trebled under the False Claims Act. The complaint alleges that the company improperly charged certain independent research and development costs to its government contracts with respect to the years 1994 through 1999. The company denies the allegations and intends to vigorously defend the matter. Trial is scheduled for August 18, 2003.
Environmental Matters
As previously reported, on December 18, 2000, the Mississippi Department of Environmental Quality (MDEQ) delivered to the Ingalls subsidiary of Litton, a notice of violation alleging use of non-compliant coatings, opacity violations and VOC emissions violations. The MDEQ subsequently requested that Ingalls, now named Northrop Grumman Ship Systems, Inc. (NGSS), perform an air permit compliance review. NGSS and the MDEQ have reached agreement on the terms of a full and complete settlement of the alleged air violations. Under the Agreed Order, NGSS will pay $350,000 to the MDEQ within 30 days after entry of the Order, and expend an additional $600,000 in capital expenditures toward implementation of an agreed upon Supplemental Environmental Project. The Agreed Order was entered on July 7, 2003. NGSS must remit the $350,000 payment by August 6, 2003.
Other Matters
Like many other industrial companies in recent years, and as a result of acquisition activities, the company is a defendant in lawsuits alleging personal injury as a result of exposure to asbestos integrated into its premises and certain historical products. The company no longer incorporates asbestos in any currently manufactured products. Many of these claims have been dismissed with no payment and the remaining resolved claims have involved
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amounts that were not material either singly or in the aggregate. Based on the information available to the company as of the date of filing of this report, the company does not believe that disposition of any or all of these matters would have a material adverse effect upon it.
All of the company’s segments engage in international business, for which the company maintains a large number of sales representatives and consultants who are not employees of the company. Foreign sales by their very nature are subject to greater variability in risk than the company’s domestic sales, particularly to the U.S. Government. International sales and services subject the company to numerous stringent U.S. and foreign laws and regulations, including, without limitation, regulations relating to import-export control, repatriation of earnings, exchange controls, the Foreign Corrupt Practices Act and the anti-boycott provisions of the U.S. Export Administration Act. Failure by the company or its sales representatives or consultants to comply with these laws and regulations could result in administrative, civil or criminal liabilities and could in the extreme case result in suspension of the company’s export privileges, which could have a material adverse consequence.
Item 4. Submission of Matters to a Vote of Security Holders
a)
Annual Meeting –
The annual meeting of stockholders of Northrop Grumman Corporation was held May 21, 2003.
Election of Directors –
The following Class III Director nominees were elected at the annual meeting:
John T. Chain, Jr.
Vic Fazio
Charles R. Larson
Ronald D. Sugar
b)
The Directors whose terms of office continue are:
Lewis W. Coleman
Phillip Frost
Kent Kresa
Charles H. Noski
Jay H. Nussbaum
Philip A. Odeen
Aulana L. Peters
John Brooks Slaughter
c)
The matters voted upon at the meeting and the results of each vote are as follows:
Votes
For
Withheld
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Against
Abstaining
Broker
Non-Votes
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
(b) Reports on Form 8-K
A report on Form 8-K was dated and submitted July 28, 2003, by Northrop Grumman Corporation including as an exhibit pursuant to Item 7 and furnishing as an exhibit pursuant to Item 12 information with respect to financial results for the quarter ended June 30, 2003.
A report on Form 8-K was dated and submitted April 10, 2003, by Northrop Grumman Corporation furnishing as an exhibit pursuant to Item 9 the First Amendment dated as of November 26, 2002 to the Five-Year
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Revolving Credit Agreement dated as of March 30, 2001, among Northrop Grumman Corporation, Northrop Grumman Systems Corporation and Litton Industries, Inc. (predecessor-in-interest to Northrop Grumman Systems Corporation), as borrowers, and the lenders and agents specified therein.
A report on Form 8-K was dated and submitted April 29, 2003, by Northrop Grumman Corporation including as an exhibit pursuant to Item 7 and furnishing as an exhibit pursuant to Item 9 information with respect to financial results for the quarter ended March 31, 2003.
A report on Form 8-K was dated March 21, 2003, and submitted March 24, 2003, by Northrop Grumman Corporation, furnishing pursuant to Item 9 a transmittal letter to the Securities and Exchange Commission and certifications of its Chairman and Chief Executive Officer and Corporate Vice President and Chief Financial Officer in connection with its Annual Report on Form 10-K for the year ended December 31, 2002. Such certifications were made pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
NORTHROP GRUMMANCORPORATION (Registrant)
/S/ SANDRA J. WRIGHT
Sandra J. Wright
Corporate Vice President and Controller
/S/ JOHN H. MULLAN
John H. Mullan
Corporate Vice President and Secretary
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