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Northrop Grumman 10-Q 2006
Form 10-Q
Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended March 31, 2006

 

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                Commission File Number
to                1-16411

 

NORTHROP GRUMMAN CORPORATION

(Exact name of registrant as specified in its charter)

 

DELAWARE   95-4840775
(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.

 

Yes  x    No  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 126-2 of the Exchange Act.

 

Large Accelerated filer  x    Accelerated Filer  ¨    Non-accelerated filer  ¨

 

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

 

Yes  ¨    No  x

 

APPLICABLE ONLY TO CORPORATE ISSUERS

 

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

 

As of April 21, 2006, 343,763,812 shares of common stock were outstanding.

 



Table of Contents

NORTHROP GRUMMAN CORPORATION

 

TABLE OF CONTENTS

 

          Page

PART I – FINANCIAL INFORMATION

Item 1.

   Financial Statements (Unaudited)     
    

Consolidated Condensed Statements of Financial Position

   I-1
    

Consolidated Condensed Statements of Income

   I-3
    

Consolidated Condensed Statements of Comprehensive Income

   I-4
    

Consolidated Condensed Statements of Cash Flows

   I-5
    

Consolidated Condensed Statements of Changes in Shareholders’ Equity

   I-7
    

Notes to Consolidated Condensed Financial Statements

    
    

  1. Basis of Presentation

   I-8
    

  2. New Accounting Standards

   I-8
    

  3. Business Acquisitions and Divestitures

   I-8
    

  4. Segment Information

   I-9
    

  5. Earnings Per Share

   I-11
    

  6. Investment in TRW Auto

   I-12
    

  7. Goodwill and Other Purchased Intangible Assets

   I-12
    

  8. Impact from Hurricane Katrina

   I-13
    

  9. Litigation

   I-14
    

10. Commitments and Contingencies

   I-15
    

11. Retirement Benefits

   I-16
    

12. Stock-Based Compensation

   I-17
    

Report of Independent Registered Public Accounting Firm

   I-20

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations     
    

Overview

   I-21
    

Critical Accounting Policies, Estimates, and Judgments

   I-21
    

Consolidated Operating Results

   I-21
    

Segment Operating Results

   I-23
    

Backlog

   I-30
    

Liquidity and Capital Resources

   I-31
    

New Accounting Standards

   I-32
    

Forward-Looking Information

   I-32

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk    I-33

Item 4.

   Controls and Procedures    I-33

PART II – OTHER INFORMATION

Item 1.

   Legal Proceedings    II-1

Item 1A.

   Risk Factors    II-1

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    II-3

Item 3.

   Defaults Upon Senior Securities    II-4

Item 4.

   Submission of Matters to a Vote of Security Holders    II-4

Item 5.

   Other Information    II-4

Item 6.

   Exhibits    II-4
     Signatures    II-5

 

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NORTHROP GRUMMAN CORPORATION

 

PART I. FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

CONSOLIDATED CONDENSED STATEMENTS OF FINANCIAL POSITION

(Unaudited)

 

$ in millions    March 31,
2006
   December 31,
2005

Assets:

             

Cash and cash equivalents

   $ 373    $ 1,605

Accounts receivable, net of progress payments of $32,877 in 2006 and $31,888 in 2005

     4,144      3,656

Inventoried costs, net of progress payments of $1,209 in 2006 and $1,162 in 2005

     1,294      1,174

Deferred income taxes

     783      783

Prepaid expenses and other current assets

     251      331

Total current assets

     6,845      7,549

Property, plant, and equipment, net of accumulated depreciation of $2,716 in 2006 and $2,600 in 2005

     4,404      4,404

Goodwill

     17,383      17,383

Other purchased intangibles, net of accumulated amortization of $1,463 in 2006 and $1,421 in 2005

     1,231      1,273

Prepaid retiree benefits cost and intangible pension asset

     2,903      2,925

Other assets

     751      680

Total assets

   $ 33,517    $ 34,214

 

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$ in millions    March 31,
2006
    December 31,
2005
 

Liabilities and Shareholders’ Equity:

                

Notes payable to banks

   $ 66     $ 50  

Current portion of long-term debt

     776       1,214  

Trade accounts payable

     1,495       1,767  

Accrued employees’ compensation

     1,085       1,109  

Advances on contracts

     1,634       1,643  

Income taxes payable

     742       668  

Other current liabilities

     1,536       1,523  

Total current liabilities

     7,334       7,974  

Long-term debt

     3,872       3,881  

Mandatorily redeemable preferred stock

     350       350  

Accrued retiree benefits

     3,800       3,701  

Deferred income taxes

     628       595  

Other long-term liabilities

     914       885  

Total liabilities

     16,898       17,386  

Common stock, 800,000,000 shares authorized; issued and outstanding:
2006 — 343,323,683; 2005 — 347,357,291

     343       347  

Paid-in capital

     11,101       11,571  

Retained earnings

     5,318       5,055  

Accumulated other comprehensive loss

     (143 )     (145 )

Total shareholders’ equity

     16,619       16,828  

Total liabilities and shareholders’ equity

   $ 33,517     $ 34,214  

 

 

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

 

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NORTHROP GRUMMAN CORPORATION

 

CONSOLIDATED CONDENSED STATEMENTS OF INCOME

(Unaudited)

 

       Three months ended
March 31


 
$ in millions, except per share      2006        2005  

Sales and Service Revenues

                     

Product sales

     $ 4,473        $ 4,936  

Service revenues

       2,711          2,517  
   

Total sales and service revenues

       7,184          7,453  
   

Cost of Sales and Service Revenues

                     

Cost of product sales

       3,514          3,953  

Cost of service revenues

       2,380          2,243  

General and administrative expenses

       695          662  
   

Operating margin

       595          595  

Other Income (Expense)

                     

Interest income

       13          14  

Interest expense

       (90 )        (95 )

Other, net

       (1 )        82  
   

Income from continuing operations before income taxes

       517          596  

Federal and foreign income taxes

       160          198  
   

Income from continuing operations

       357          398  

Discontinued operations, net of tax

       1          11  
   

Net income

     $ 358        $ 409  
   

Basic Earnings Per Share

                     

Continuing operations

     $ 1.04        $ 1.10  

Discontinued operations

                  .03  
   

Basic earnings per share

     $ 1.04        $ 1.13  
   

Weighted average common shares outstanding, in millions

       343.3          360.7  
   

Diluted Earnings Per Share

                     

Continuing operations

     $ 1.02        $ 1.08  

Discontinued operations

                  .03  
   

Diluted earnings per share

     $ 1.02        $ 1.11  
   

Weighted average diluted shares outstanding, in millions

       350.8          367.0  
   

 

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

 

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NORTHROP GRUMMAN CORPORATION

 

CONSOLIDATED CONDENSED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

       Three months ended
March 31


 
$ in millions      2006      2005  

Net income

     $ 358      $ 409  

Other Comprehensive Income (Loss)

                   

Change in cumulative translation adjustment

       3        1  

Unrealized loss on marketable securities, net of tax of $2

       (1 )         

Reclassification adjustment on sale of marketable securities, net of tax of $15

                (29 )
   

Other comprehensive income (loss), net of tax

       2        (28 )
   

Comprehensive income

     $ 360      $ 381  
   

 

 

 

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

 

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NORTHROP GRUMMAN CORPORATION

 

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Three months ended
March 31


 
$ in millions        2006             2005      

Operating Activities

                

Sources of Cash

                

Cash received from customers

                

Progress payments

   $ 1,624     $ 1,988  

Other collections

     5,122       5,421  

Income tax refunds received

     8       5  

Interest received

     15       17  

Other cash receipts

     36       7  
   

Total sources of cash

     6,805       7,438  
   

Uses of Cash

                

Cash paid to suppliers and employees

     6,663       6,913  

Interest paid

     130       133  

Income taxes paid

     68       27  

Excess tax benefits from stock-based compensation

     39          

Payments for litigation settlement

             99  

Other cash payments

     20       3  
   

Total uses of cash

     6,920       7,175  
   

Net cash (used in) provided by operating activities

     (115 )     263  
   

Investing Activities

                

Proceeds from sale of businesses, net of cash divested

     26       56  

Payment for businesses purchased, net of cash acquired

             (313 )

Proceeds from sale of property, plant, and equipment

     6       4  

Additions to property, plant, and equipment

     (173 )     (197 )

Proceeds from insurance carrier

     37          

Proceeds from sale of investment

             143  

Investment in unconsolidated affiliate

     (35 )        

Other investing activities, net

     (4 )     (3 )
   

Net cash used in investing activities

     (143 )     (310 )
   

Financing Activities

                

Borrowings under lines of credit

     16       54  

Repayment of borrowings under lines of credit

             (1 )

Principal payments of long-term debt

     (436 )     (31 )

Proceeds from stock option exercises

     286       21  

Dividends paid

     (92 )     (82 )

Excess tax benefits from stock-based compensation

     39          

Common stock repurchases

     (787 )     (360 )
   

Net cash used in financing activities

     (974 )     (399 )
   

Decrease in cash and cash equivalents

     (1,232 )     (446 )

Cash and cash equivalents, beginning of period

     1,605       1,230  
   

Cash and cash equivalents, end of period

   $ 373     $ 784  
   

 

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NORTHROP GRUMMAN CORPORATION

 

 

     Three months ended
March 31


 
$ in millions        2006             2005      

Reconciliation of Income from Continuing Operations to Net Cash (Used in) Provided by Operating Activities

                

Income from continuing operations

   $ 357     $ 398  

Adjustments to reconcile to net cash (used in) provided by operating activities

                

Depreciation

     135       124  

Amortization of intangible assets

     42       54  

Stock-based compensation

     51       20  

Excess tax benefits from stock-based compensation

     (39 )        

Loss on disposals of property, plant, and equipment

     1       2  

Amortization of long-term debt premium

     (4 )     (5 )

Gain on sale of investments

             (70 )

Decrease (increase) in

                

Accounts receivable

     (1,477 )     (1,101 )

Inventoried costs

     (167 )     (116 )

Prepaid expenses and other current assets

     47       (2 )

Increase (decrease) in

                

Progress payments

     1,036       1,008  

Accounts payable and accruals

     (331 )     (272 )

Deferred income taxes

     27       15  

Income taxes payable

     74       147  

Retiree benefits

     119       47  

Other non-cash transactions, net

     14       14  
   

Net cash (used in) provided by operating activities

   $ (115 )   $ 263  
   

Non-Cash Investing and Financing Activities

                

Sale of businesses

                

Liabilities assumed by purchaser

   $ 11     $ 38  
   

Purchase of business

                

Fair value of assets acquired, including goodwill

           $ 352  

Consideration given for businesses purchased

             (313 )
   

Liabilities assumed

           $ 39  
   

 

 

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

 

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NORTHROP GRUMMAN CORPORATION

 

CONSOLIDATED CONDENSED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)

 

     Three months ended
March 31


 
$ in millions, except per share        2006             2005      

Common Stock

                

At beginning of period

   $ 347     $ 364  

Common stock repurchased

     (12 )     (6 )

Employee stock awards and options

     8       1  
   

At end of period

     343       359  
   

Paid-in Capital

                

At beginning of period

     11,571       12,426  

Common stock repurchased

     (775 )     (331 )

Employee stock awards and options

     305       10  
   

At end of period

     11,101       12,105  
   

Retained Earnings

                

At beginning of period

     5,055       4,014  

Net income

     358       409  

Dividends

     (95 )     (82 )
   

At end of period

     5,318       4,341  
   

Unearned Compensation

                

At beginning of period

             (3 )
   

At end of period

             (3 )
   

Accumulated Other Comprehensive Loss

                

At beginning of period

     (145 )     (101 )

Change in cumulative translation adjustment

     3       1  

Unrealized loss on marketable securities, net of tax

     (1 )        

Reclassification adjustment on sale of marketable securities, net of tax

             (29 )
   

At end of period

     (143 )     (129 )
   

Total shareholders’ equity

   $ 16,619     $ 16,673  
   

Cash dividends per share

   $ .26     $ .23  
   

 

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

 

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NORTHROP GRUMMAN CORPORATION

 

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

(Unaudited)

 

1.  BASIS OF PRESENTATION

 

Principles of Consolidation – The unaudited consolidated condensed financial statements include the accounts of Northrop Grumman Corporation (Northrop Grumman or the company) and its subsidiaries. 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 financial position, results of operations, 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 contained in the company’s 2005 Annual Report on Form 10-K.

 

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

 

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

 

Financial Statement Reclassifications – Certain amounts in the prior year financial statements and related notes have been reclassified to conform to the 2006 presentation.

 

Effective January 1, 2006, the company established a new reportable segment, Northrop Grumman Technical Services (Technical Services), to leverage existing business strengths and synergies in the rapidly expanding areas of logistics support, sustainment and technical services. Technical Services consolidates multiple programs in logistics operations from the Electronics (formerly Electronic Systems), Integrated Systems, Mission Systems, and Information Technology segments.

 

2.  NEW ACCOUNTING STANDARDS

 

None of the new accounting pronouncements that became effective during the periods presented had a material effect on the company’s financial position or results of operations. The expanded disclosure requirements of Statement of Financial Accounting Standards No. 123R – Share-Based Payment (SFAS No. 123R) are presented in Note 12.

 

3.  BUSINESS ACQUISITIONS AND DIVESTITURES

 

Interconnect – On February 24, 2006, the company sold the assembly business of Interconnect Technologies (Interconnect) for net cash proceeds of $26 million. Included in discontinued operations is an after-tax gain on

 

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NORTHROP GRUMMAN CORPORATION

 

sale of $5 million. The results of operations of the assembly business of Interconnect, reported in the Electronics segment, were not material to any of the periods presented and have therefore not been reclassified as discontinued operations.

 

Enterprise Information Technology – In January 2006, management announced its strategic decision to shut down the value-added reseller business reported within the Information Technology segment as the Enterprise Information Technology business area. Sales for this business for the three months ended March 31, 2006, and 2005, were $114 million and $167 million, respectively. The shut down of this business is expected to be completed by the end of 2006 and is not expected to have a material effect on the company’s consolidated financial position, results of operations, or cash flows. The results of operations of this business will be reclassified to discontinued operations in the period in which the shut down is completed.

 

Teldix – On March 31, 2005, the company sold Teldix GmbH (Teldix) for $56 million in cash and recognized an after-tax gain of $11 million in discontinued operations. Subsequent purchase price adjustment pursuant to the sale agreement increased the after-tax gain to $14 million for the year ended December 31, 2005. The results of operations of Teldix, reported in the Electronics segment, were not material to any of the periods presented and have therefore not been reclassified as discontinued operations.

 

Integic – On March 21, 2005, the company acquired privately held Integic Corporation (Integic) for $319 million, which included transaction costs of $6 million. Integic specializes in enterprise health and business process management solutions. The assets, liabilities, and results of operations of Integic were not material and thus pro-forma information is not presented.

 

4.  SEGMENT INFORMATION

 

Effective January 1, 2006, the company established a new reportable segment, Technical Services, to leverage existing business strengths and synergies in the rapidly expanding areas of logistics support, sustainment and technical services. Technical Services consolidates multiple programs in logistics operations from the Electronics (formerly Electronic Systems), Integrated Systems, Mission Systems and Information Technology segments.

 

For presentation and discussion purposes, the company’s seven reportable segments are categorized into four primary businesses. The Mission Systems, Information Technology and Technical Services segments are presented as Information & Services. The Integrated Systems and Space Technology segments are presented as Aerospace. The Electronics and Ships segments are presented as separate businesses. The Ships segment includes the aggregated results of the Newport News and Ship Systems operating segments.

 

Effective January 1, 2006, in order to provide a more relevant depiction of the management and performance of the company’s businesses, sales and segment operating margin in the following tables were revised to include margin on intersegment sales for all periods presented. Intersegment amounts are then eliminated upon consolidation of the segments.

 

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The following table presents segment sales and service revenues for the three months ended March 31, 2006, and 2005.

 

     Three months ended
March 31


 
$ in millions        2006             2005      

Sales and Service Revenues

                

Information & Services

                

Mission Systems

   $ 1,264     $ 1,254  

Information Technology

     1,057       1,034  

Technical Services

     275       274  
   

Total Information & Services

     2,596       2,562  

Aerospace

                

Integrated Systems

     1,437       1,287  

Space Technology

     855       863  
   

Total Aerospace

     2,292       2,150  

Electronics

     1,509       1,547  

Ships

     1,133       1,514  

Other

             11  

Intersegment eliminations

     (346 )     (331 )
   

Total sales and service revenues

   $ 7,184     $ 7,453  
   

 

The following table presents segment operating margin reconciled to total operating margin for the three months ended March 31, 2006, and 2005.

 

     Three months ended
March 31


 
$ in millions        2006             2005      

Operating Margin

                

Information & Services

                

Mission Systems

   $ 117     $ 93  

Information Technology

     75       76  

Technical Services

     13       12  
   

Total Information & Services

     205       181  

Aerospace

                

Integrated Systems

     149       142  

Space Technology

     71       67  
   

Total Aerospace

     220       209  

Electronics

     177       162  

Ships

     68       107  

Other

             (1 )

Intersegment eliminations

     (26 )     (20 )
   

Total segment operating margin

     644       638  

Non-segment factors affecting operating margin

                

Unallocated expenses

     (35 )     (27 )

Net pension expense adjustment

     (10 )     (11 )

Reversal of royalty income included above

     (4 )     (5 )
   

Total operating margin

   $ 595     $ 595  
   

 

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

 

Net Pension Expense Adjustment – The net pension expense adjustment reflects the excess pension expense determined in accordance with accounting principles generally accepted in the United States of America over the pension expense included in the segment’s cost of sales to the extent that these costs are currently recognized under CAS. For the three months ended March 31, 2006, and 2005, pension expense determined in accordance with accounting principles generally accepted in the United States of America was $112 million and $103 million, respectively, and CAS pension expense was $102 million and $92 million, respectively.

 

5.  EARNINGS PER SHARE

 

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

 

Diluted Earnings Per Share – The dilutive effect of stock options and other stock awards granted to employees under stock-based compensation plans totaled 7.5 million shares and 6.3 million shares for the three months ended March 31, 2006, and 2005, respectively. For the three months ended March 31, 2006, the dilutive effect of the potential share settlement of the accelerated stock repurchase program discussed below is also included. Shares issuable pursuant to the mandatorily redeemable preferred stock are not included in the diluted earnings per share calculations because their effect was not dilutive for the periods presented. The weighted-average diluted shares outstanding exclude stock options that have an exercise price in excess of the average market price of the company’s common stock during the period. The number of options excluded was approximately 700,000 for the three months ended March 31, 2006, and was approximately 7 million for the three months ended March 31, 2005.

 

Share Repurchases – On October 24, 2005, the company’s board of directors authorized a share repurchase program of up to $1.5 billion of its outstanding common stock, which commenced in November 2005 and is expected to be completed by the end of 2006.

 

Under this program, the company entered into an initial agreement with Credit Suisse, New York Branch (Credit Suisse) on November 4, 2005, to repurchase approximately 9.1 million shares of common stock at an initial price of $55.15 per share for a total of $500 million. Credit Suisse immediately borrowed shares that were sold to and canceled by the company. Subsequently, Credit Suisse purchased shares in the open market to settle its share borrowings. On March 1, 2006, Credit Suisse completed its purchases under this agreement, and the company paid $37 million for the final price adjustment under the terms of the agreement. The final average purchase price was $59.05 per share.

 

The company entered into a second agreement with Credit Suisse on March 6, 2006, to repurchase approximately 11.6 million shares of common stock at an initial price of $64.78 per share for a total of $750 million. Under this agreement, Credit Suisse immediately borrowed shares that were sold to and canceled by the company. Subsequently, Credit Suisse 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 on the actual cost of the shares subsequently purchased by Credit Suisse. The price adjustment can be settled, at the company’s option, in cash or in shares of common stock.

 

As of March 31, 2006, Credit Suisse had purchased 3.8 million shares, or 33 percent of the shares under the agreement, at an average price per share of $68.30 net of commissions, interest and other fees. Assuming Credit Suisse purchases the remaining shares at a price per share equal to the closing price of the company’s common stock on March 31, 2006 ($68.29), the company would be required to pay approximately $38.1 million or issue approximately 550,000 shares of common stock to complete the transaction. The settlement amount may increase

 

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or decrease depending upon the average price paid for the shares under the program. Settlement is expected to occur in the second quarter of 2006, depending upon the timing and pace of the purchases, and would result in an adjustment to shareholders’ equity.

 

Share repurchases take place at management’s discretion and under pre-established, non-discretionary programs from time to time, depending on market conditions, in the open market, and in privately negotiated transactions. The company retires its common stock upon repurchase and has not made any purchases of common stock other than in connection with these publicly announced repurchase programs.

 

6.  INVESTMENT IN TRW AUTO

 

On March 11, 2005, the company sold 7.3 million of its TRW Auto common shares for $143 million, and recorded an after-tax gain of $45 million. The sale reduced the company’s ownership of TRW Auto to 9.7 million common shares. The remaining investment is carried at cost of $97 million and included in “Miscellaneous other assets” as of March 31, 2006, and December 31, 2005. The company does not consider this investment to be critical to its ongoing business operations. Any future sale would be dependent upon the events described in the Second Amended and Restated Stockholders Agreement dated January 28, 2004, between the company and TRW Auto.

 

7.  GOODWILL AND OTHER PURCHASED INTANGIBLE ASSETS

 

Goodwill

Effective January 1, 2006, the company realigned businesses among four of its operating segments to form a new segment. As a result of this realignment, goodwill of approximately $731 million was reallocated among these five segments.

 

The changes in the carrying amounts of goodwill for the three months ended March 31, 2006, are as follows:

 

$ in millions   Balance as of
December 31, 2005
  Goodwill
transferred
in segment
realignment
    Balance as of
March 31, 2006

Mission Systems

  $ 4,256   $ (313 )   $ 3,943

Information Technology

    2,649     (403 )     2,246

Technical Services

          731       731

Integrated Systems

    992     (4 )     988

Space Technology

    3,295             3,295

Electronics

    2,575     (11 )     2,564

Ships

    3,616             3,616
   

 


 

   

 


 

Total

  $ 17,383   $     $ 17,383
   

 


 

   

 


 

 

Purchased Intangible Assets

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

 

    March 31, 2006

  December 31, 2005

$ in millions   Gross
Carrying
Amount
  Accumulated
Amortization
    Net
Carrying
Amount
  Gross
Carrying
Amount
  Accumulated
Amortization
    Net
Carrying
Amount

Contract and program intangibles

  $ 2,594   $ (1,398 )   $ 1,196   $ 2,594   $ (1,357 )   $ 1,237

Other purchased intangibles

    100     (65 )     35     100     (64 )     36
 

Total

  $ 2,694   $ (1,463 )   $ 1,231   $ 2,694   $ (1,421 )   $ 1,273
 

 

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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 ended March 31, 2006, was $42 million.

 

The table below shows expected amortization for purchased intangibles for the remainder of 2006 and for the next five years:

 

$ in millions     

Year Ended December 31

    

2006 (April 1 - December 31)

   93

2007

   121

2008

   111

2009

   101

2010

   81

2011

   42
    
    

 

8.  IMPACT FROM HURRICANE KATRINA

 

During the third quarter of 2005, the company’s operations in the Gulf Coast area of the U. S. were significantly impacted by Hurricane Katrina. As a result of the hurricane, the Ships segment suffered property damage, contract cost growth, and work delays.

 

As of March 31, 2006, management estimates that the total cost to repair or replace assets damaged by the storm and the costs to clean up and restore its operations, excluding business interruption, will total approximately $850 million, substantially all of which is expected to be recovered through the company’s comprehensive property damage insurance. Through March 31, 2006, the company incurred $252 million to clean-up and restore its facilities, including capital expenditures. The company is continuing to assess its damage estimates as the process of repairing its operations is performed.

 

Through March 31, 2006, the company has received $181 million in insurance proceeds, the majority of which represent the reimbursement of clean-up and recovery costs and funds to replace facilities destroyed by the storm. As of March 31, 2006, the company has written off $61 million in assets that were completely destroyed by the storm. The company is in the process of managing a substantial repair and restoration activity to identify, estimate and secure the repairs needed to restore its affected operations. This includes developing the company’s extensive claim submissions to its insurers, and overseeing the repair and restoration process. To date, the company has submitted estimated expenditures for recovery that are substantially in excess of the insurance proceeds received, and is awaiting resolution of its submissions.

 

The company’s comprehensive property insurance includes coverage for business interruption effects caused by the storm, however, the company is unable to currently estimate the amount of any recovery or the period in which its claims related to business interruption will be resolved. Accordingly, no such amounts have been recognized by the company in the accompanying consolidated condensed financial statements.

 

In accordance with cost accounting regulations relating to U. S. Government contractors, recovery of property damages in excess of the net book value of the damaged assets as well as losses on property damage that are not recovered through insurance are required to be included in the company’s overhead pools and allocated to current contracts under a systematic process. The company is currently in discussions with its government customers regarding the allocation methodology to be used to account for these differences. Depending upon the outcome of these discussions, and the ultimate resolution of the company’s damage claims with its insurance providers, the company may be required to recognize additional cost growth on its contracts and cumulative downward adjustment to its contract profit rates at a future date.

 

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The insurance provider for coverage of damages over $500 million advised management of a disagreement regarding coverage of losses in excess of $500 million and this matter is currently being litigated by the company as described in Note 9. The company believes that its insurance policies are enforceable and intends to pursue all of its available rights and remedies. However, based on the current status of the litigation between the company and its insurance provider, no assurances can be made as to the ultimate outcome of this matter. To the extent that its insurance recoveries are inadequate to fund the repair and restoration costs that the company deems necessary, the company will pursue other means for funding the shortfall, including funding from its current operations.

 

9.  LITIGATION

 

Litigation – Various claims and legal proceedings arise in the ordinary course of business and are pending against the company and its properties. Based upon the information available, the company does not believe that the resolution of any of these various claims and legal proceedings will have a material adverse effect on its 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 or compensatory or treble damages. U.S. Government regulations provide that certain findings against a contractor may lead to suspension or debarment from future U.S. Government contracts or the loss of export privileges for a company or an operating division or subdivision. Suspension or debarment could have a material adverse effect on the company because of its reliance on government contracts.

 

At a briefing in October 2005, the U.S. Department of Justice and a classified U.S. Government customer apprised the company of potential substantial claims relating to certain microelectronic parts produced by the Space and Electronics Sector of former TRW Inc., now a component of the company. It is unclear whether the potential claims relate to a civil False Claims Act case that remains under seal in the U.S. District Court for the Central District of California. The company responded to the allegations, and the parties continue to meet to better understand the factual basis of the claims before the government decides whether to institute formal legal proceedings or to pursue some other form of resolution. Because of the highly technical nature of the issues involved and their classified status, final resolution of this matter could take a considerable amount of time, particularly if litigation should ensue. If the U.S. Department of Justice were to pursue litigation and were to be ultimately successful on its theories of liability and compensatory damages, the effect upon the company’s financial position, results of operations, and cash flows would be material. Based upon its review to date, the company believes that it acted appropriately in this matter but can give no assurance that its view will prevail. The company is not able to estimate the amount of damages, if any, at this time.

 

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

 

Insurance Recovery – Damage from Hurricane Katrina is covered by the company’s comprehensive property insurance program. The insurance provider for coverage in excess of $500 million has advised the company of a disagreement regarding coverage for certain losses experienced by the company. Management believes its losses are covered by insurance and has filed a declaratory relief action in the U. S. District Court in Los Angeles, California, seeking a judicial determination that its property insurance program covers all Katrina-related losses in excess of the applicable deductible. Trial on the issue of coverage is set to begin in April 2007. The amount and timing of insurance recoveries remain uncertain due to the difficulty in estimating total damage and the pending legal action with the insurance provider.

 

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10.  COMMITMENTS AND CONTINGENCIES

 

Accelerated Share Repurchase – On March 6, 2006, the company entered into an accelerated share repurchase agreement with Credit Suisse. As of March 31, 2006, the company would be required to pay approximately $38.1 million or issue approximately 550,000 shares of its common stock 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 second quarter of 2006, depending upon the timing and pace of open market purchases by Credit Suisse, and would result in an adjustment to shareholders’ equity.

 

Contract Performance Contingencies – Contract profit margins may include estimates of costs not contractually agreed to between the customer and the company for matters such as contract changes, negotiated settlements, claims and requests for equitable adjustment for previously unanticipated contract costs. These estimates are based upon management’s best assessment of the underlying causal events and circumstances, and are included in determining contract profit margins to the extent of expected recovery based on contractual entitlements and the probability of successful negotiation with the customer. As of March 31, 2006, the amounts are not material individually or in the aggregate.

 

Income Tax Matters – In December 2004, the IRS completed its audits of the B-2 program for the years ended December 31, 1997, through December 31, 2000, and proposed an adjustment that does not affect the company’s income tax liability, but could have resulted in an obligation to pay an amount of interest to the IRS that was significant. In November 2005, the IRS informally advised the company of its intention to cease to pursue its proposed adjustment and close its investigation of tax years 1997 through 2000, pending a final review and approval by the U.S. Congress’ Joint Committee on Taxation. The company does not believe that resolution of this matter will have a material effect on the company’s consolidated financial position, results of operations, or cash flows.

 

Environmental Matters – In accordance with company policy on environmental remediation, the estimated cost to complete remediation has been accrued where it is probable that the company will incur such costs in the future to address environmental impacts at currently or formerly owned or leased operating facilities, or at sites where it has been named a Potentially Responsible Party (PRP) by the Environmental Protection Agency, or similarly designated by other environmental agencies. To assess the potential impact on the company’s consolidated financial statements, management estimates the total reasonably possible remediation costs that could be incurred by the company, taking into account currently available facts on each site as well as the current state of technology and prior experience in remediating contaminated sites. These estimates are reviewed periodically and adjusted to reflect changes in facts and technical and legal circumstances. Management estimates that at March 31, 2006, the range of reasonably possible future costs for environmental remediation sites is $245 million to $355 million, of which $273 million is accrued. Factors that could result in changes to the company’s estimates include: modification of planned remedial actions, increase or decrease in the estimated time required to remediate, discovery of more extensive contamination than anticipated, changes in laws and regulations affecting remediation requirements, and improvements in remediation technology. Should other PRPs not pay their allocable share of remediation costs, the company may have to incur costs in addition to those already estimated and accrued. Although management cannot predict whether new information gained as projects progress will materially affect the estimated liability accrued, management does not anticipate that future remediation expenditures will have a material adverse effect on the company’s consolidated financial position, results of operations, or cash flows.

 

Co-Operative Agreements – In 2003, Ships executed agreements with the states of Mississippi and Louisiana, respectively, whereby Ships will lease facility improvements and equipment from Mississippi and from a non-profit economic development corporation in Louisiana in exchange for certain commitments by Ships to these states. Under the Mississippi agreement, Ships is required to match the state’s funding with Modernization and Sustaining & Maintenance expenditures of up to $313 million and create up to 2,000 new full-time jobs in Mississippi by December 2009. As of March 31, 2006, $100 million had been appropriated in 2002, 2003 and 2004 by Mississippi requiring, through a Memorandum of Understanding (MOU) with the Mississippi

 

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Development Authority, an increase of 1,334 jobs and matching expenditures of $201 million. Ships has fully complied with both requirements. On March 27, 2006, the final appropriation of $56 million was approved by the legislature and will require the creation of the final 666 new full-time jobs in Mississippi and matching expenditures of $112 million. Under the Louisiana agreement, Ships is required to match the state’s funding for expenditures up to $56 million through 2007, and employ a minimum of 5,200 full-time employees in 16 of the 32 fiscal quarters beginning January 1, 2003, and ending December 31, 2010. As of March 31, 2006, $56 million has been appropriated by Louisiana and employment commitments for 13 of the 16 quarters have been fulfilled and the matching funds requirement has been met.

 

Failure by Ships to meet these commitments would result in reimbursement by Ships to Mississippi and Louisiana in accordance with the respective agreements. As of March 31, 2006, management believes that Ships is in compliance with its commitments to date under these agreements, and expects that all future commitments under these agreements will be met based on the most recent Ships business plan.

 

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 by insurance companies principally to guarantee the performance on certain contracts and to support the company’s self-insured workers’ compensation plans. At March 31, 2006, there were $490 million of unused stand-by letters of credit, $80 million of bank guarantees, and $554 million of surety bonds outstanding.

 

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

 

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

 

11.  RETIREMENT BENEFITS

 

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

 

     Three months ended March 31

 
     Pension
Benefits


    Medical and
Life Benefits


 
$ in millions      2006         2005         2006         2005    

Components of Net Periodic Benefit Cost

                                

Service cost

   $ 185     $ 169     $ 18     $ 18  

Interest cost

     291       273       47       45  

Expected return on plan assets

     (393 )     (367 )     (13 )     (12 )

Amortization of:

                                

Prior service costs

     9       13       (2 )        

Net loss from previous years

     20       15       8       6  
   

Net periodic benefit cost from continuing operations

   $ 112     $ 103     $ 58     $ 57  
   

Defined contribution plans cost

   $ 67     $ 63                  
   

 

Employer Contributions – The company expects to contribute approximately $441 million to its pension plans and approximately $192 million to its medical and life benefit plans in 2006. As of March 31, 2006, contributions of $29 million and $23 million have been made to the company’s pension plans and its medical and life benefit plans, respectively.

 

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12.  STOCK-BASED COMPENSATION

 

At March 31, 2006, the company had share-based awards outstanding under three stock-based compensation plans: the 2001 Long-Term Incentive Stock Plan, the 1993 Long-Term Incentive Stock Plan, both applicable to employees, and the 1995 Stock Option Plan for Non-Employee Directors. All of these plans were approved by the company’s shareholders. Share-based awards under these plans consist of stock option awards (Stock Options) and restricted stock awards (Stock Awards). A detailed description of these plans can be found in the company’s 2005 Annual Report on Form 10-K.

 

Prior to January 1, 2006, the company applied Accounting Principles Board Opinion No. 25 – Accounting for Stock Issued to Employees and related interpretations in accounting for awards made under the company’s stock-based compensation plans. Stock Options granted under the plans had an exercise price equal to or greater than the market value of the common stock on the date of the grant, and accordingly, no compensation expense was recognized. Stock Awards were valued at their fair market value measured at the date of grant, updated periodically using the mark-to-market method, and compensation expense was recognized over the vesting period of the award.

 

Accelerated Vesting – On May 16, 2005, in connection with an evaluation of the company’s overall incentive compensation strategy, the Compensation and Management Development Committee of the company’s board of directors approved accelerating the vesting for all outstanding unvested employee Stock Options (excluding options held by elected officers), effective September 30, 2005. As part of its evaluation, management considered the amount of compensation expense that would otherwise have been recognized in the company’s results of operations upon the adoption of SFAS No. 123R. The accelerated options had a weighted average exercise price of $51 with original vesting dates through April 2009. The charge associated with the acceleration of vesting was not material.

 

Adoption of New Standard – Effective January 1, 2006, the company adopted the provisions of SFAS No. 123R using the modified-prospective transition method and the disclosures that follow are based on applying SFAS No. 123R. Under this transition method, compensation expense recognized during the three months ended March 31, 2006, included: (a) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 – Accounting for Stock-Based Compensation, and (b) compensation expense for all share-based awards granted on or after January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R. In accordance with the modified-prospective transition method, results for prior periods have not been restated. All of the company’s stock award plans are considered equity plans under SFAS No. 123R, and compensation expense recognized as previously described is net of estimated forfeitures of share based awards over the vesting period. The effect of adopting SFAS No. 123R was not material to the company’s income from continuing operations and net income for the three months ended March 31, 2006, and the cumulative effect of adoption using the modified-prospective transition method was similarly not material.

 

Compensation Expense – Total stock-based compensation for the three months ended March 31, 2006 was $48 million, of which $3 million related to Stock Options and $45 million related to Stock Awards. For the three months ended March 31, 2005, total stock-based compensation was $25 million, principally consisting of Stock Awards. Tax benefits recognized in the consolidated condensed statements of income for stock-based compensation during the three months ended March 31, 2006, and 2005, were $17 million and $9 million, respectively. In addition, the company realized excess tax benefits of $34 million from the exercise of stock options and $5 million from the vesting of stock awards in the three months ended March 31, 2006. SFAS 123R requires that cash flows resulting from excess tax benefits be classified as financing cash flows in the accompanying consolidated condensed statements of cash flows.

 

Stock Options – The fair value of each of the company’s stock option awards is estimated on the date of grant using a Black-Scholes option-pricing model that uses the assumptions noted in the table below. The fair value of the company’s Stock Option awards is expensed on a straight-line basis over the vesting period of the options,

 

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which is generally four years. Expected volatility is based on an average of (1) historical volatility of the company’s stock and (2) implied volatility from traded options on the company’s stock. The risk-free rate for periods within the contractual life of the stock option award is based on the yield curve of a zero-coupon U.S. Treasury bond on the date the award is granted with a maturity equal to the expected term of the award. The company uses historical data to estimate forfeitures within its valuation model. The expected term of awards granted is derived from historical experience under the company’s stock-based compensation plans and represents the period of time that awards granted are expected to be outstanding.

 

The significant weighted average assumptions relating to the valuation of the company’s Stock Options for the three months ended March 31, 2006, and 2005, were as follows:

 

     2006      2005

Dividend yield

   1.6%      1.9%

Volatility rate

   25%      30%

Risk-free interest rate

   4.6%      3.6%

Expected option life (years)

   6.0      6.0

 

The weighted average grant date fair value of Stock Options granted during the three months ended March 31, 2006, and 2005, was $18 and $16, respectively.

 

Stock Option activity for the three months ended March 31, 2006, was as follows:

 

    Shares
Under Option
    Weighted
Average
Exercise Price
  Weighted Average
Remaining
Contractual Term
  Aggregate
Intrinsic Value
($ in millions)

Outstanding at January 1, 2006

  27,817,816     $ 48   5.5 years   $ 329

Granted

  806,690     $ 65          

Exercised

  (6,085,123 )   $ 48          
 

Outstanding at March 31, 2006

  22,539,383     $ 49   5.6 years   $ 433
 

Vested and expected to vest in the future at March 31, 2006

  22,452,654     $ 49   5.6 years   $ 433
 

Exercisable at March 31, 2006

  20,720,054     $ 48   5.4 years   $ 414
 

Available for grant at March 31, 2006

  12,613,365                  
                   

 

The total intrinsic value of options exercised during the three months ended March 31, 2006, and 2005, was $112 million and $14 million, respectively. Intrinsic value is measured using the fair market value at the date of exercise (for shares exercised) or at March 31, 2006 (for outstanding options), less the applicable exercise price.

 

Stock Awards – The fair value of Stock Awards is determined based on the closing market price of the company’s common stock on the grant date. Compensation expense for Stock Awards is measured at the grant date and recognized over the vesting period. Grants of Stock Awards with performance features are adjusted (upward or downward) at the vesting date based on achievement of the performance criteria established by the board of directors. For purposes of measuring compensation expense, the amount of shares ultimately expected to vest is estimated at each reporting date based on management’s expectations regarding the relevant performance criteria. In the table below, the share adjustment resulting from the final performance measure is considered granted, or forfeited, in the period that the related grant is vested. There were 1.9 million Stock Awards that vested in the three months ended March 31, 2005, with a total fair value of $104 million. There were 2.1 million Stock Awards granted in the three months ended March 31, 2005, with a weighted average grant date fair value of $54.

 

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Stock Award activity for the three months ended March 31, 2006, was as follows:

 

     Stock
Awards
    Weighted Average
Grant Date
Fair Value
   Weighted Average
Remaining
Contractual Term

Outstanding at January 1, 2006

   5,785,918     $ 53    0.9 years

Granted (including performance adjustment on shares vested)

   4,154,591       63     

Vested

   (2,368,780 )     56     

Forfeited

   (59,924 )     50     
 

Outstanding at March 31, 2006

   7,511,805     $ 57    2.0 years
 

Available for grant at March 31, 2006

   6,223,646             
              

 

Unrecognized Compensation Expense – At March 31, 2006, there was $387 million of unrecognized compensation expense related to unvested awards granted under the company’s stock-based compensation plans, of which $23 million relates to Stock Options and $364 million relates to Stock Awards that are expected to be charged to expense over a weighted-average period of 2 years.

 

Pro-forma Compensation Expense – Had compensation expense for the three months ended March 31, 2005, been determined based on the fair value at the grant dates for stock awards, consistent with SFAS No. 123 – Accounting for Stock-Based Compensation, net income, basic earnings per share, and diluted earnings per share would have been as shown in the table below:

 

$ in millions, except per share    Three months ended
March 31, 2005
 

Net income as reported

   $ 409  

Stock-based compensation, net of tax, included in net income as reported

     16  

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

     (27 )
   

Pro-forma net income using the fair value method

   $ 398  
   

Basic Earnings Per Share

        

As reported

   $ 1.13  

Pro-forma

   $ 1.10  

Diluted Earnings Per Share

        

As reported

   $ 1.11  

Pro-forma

   $ 1.08  

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

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 March 31, 2006, and the related consolidated condensed statements of income, comprehensive income, cash flows and changes in shareholders’ equity for the three-month periods ended March 31, 2006 and 2005. 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 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 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, 2005, and the related consolidated statements of income, comprehensive income, cash flows, and changes in shareholders’ equity for the year then ended (not presented herein); and in our report dated February 16, 2006, 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, 2005 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

 

Los Angeles, California

April 24, 2006

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

OVERVIEW

 

The following discussion should be read along with the unaudited condensed consolidated financial statements included in this Form 10-Q, as well as the company’s 2005 Annual Report on Form 10-K filed with the Securities and Exchange Commission, which provides a more thorough discussion of the company’s products and services, industry outlook, and business trends.

 

Northrop Grumman provides technologically advanced, innovative products, services, and solutions in information and services, aerospace, electronics, and shipbuilding. As a prime contractor, principal subcontractor, partner, or preferred supplier, Northrop Grumman participates in many high-priority defense and commercial technology programs in the United States and abroad. Northrop Grumman conducts most of its business with the United States (U.S.) Government, principally the Department of Defense. The company also conducts business with foreign governments and makes domestic and international commercial sales.

 

For presentation and discussion purposes, the company’s seven reportable segments are categorized into four primary businesses. The Mission Systems, Information Technology and Technical Services segments are presented as Information & Services. The Integrated Systems and Space Technology segments are presented as Aerospace. The Electronics and Ships segments are presented as separate businesses. The Ships segment includes the aggregated results of the Newport News and Ship Systems operating segments.

 

Effective January 1, 2006, in order to provide a more relevant depiction of the management and performance of the company’s businesses, sales and segment operating margin in the following tables were revised to include margin on intersegment sales for all periods presented. Intersegment amounts are then eliminated upon consolidation of the segments.

 

CRITICAL ACCOUNTING POLICIES, ESTIMATES, AND JUDGMENTS

 

The company’s financial statements are in conformity with accounting principles generally accepted in the United States of America. The preparation of the financial statements 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. Actual results could differ materially from those estimates.

 

There have been no changes in the company’s critical accounting policies during the three months ended March 31, 2006.

 

CONSOLIDATED OPERATING RESULTS

 

Selected financial highlights are presented in the table below.

 

       Three months ended
March 31


 
$ in millions, except per share          2006              2005      

Sales and service revenues

     $ 7,184      $ 7,453  

Operating margin

       595        595  

Interest income

       13        14  

Interest expense

       (90 )      (95 )

Other, net

       (1 )      82  

Federal and foreign income taxes

       160        198  

Diluted earnings per share from continuing operations

       1.02        1.08  

Net cash (used in) provided by operating activities

       (115 )      263  

 

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Sales and Service Revenues

Sales and service revenues for the three months ended March 31, 2006, decreased $269 million, or 4 percent, as compared with the same period in 2005, primarily due to decreased sales in the Ships segment. The decrease in the Ships segment was due to lower volume on the DD(X) program, as well as hurricane-related work delays on the LPD, LHD, DDG, and Coast Guard Deepwater programs.

 

Operating margin

The operating margin rate for the three months ended March 31, 2006, was 8.3 percent, as compared with 8.0 percent in the same period of 2005. The increase was primarily due to improved performance at Mission Systems, Electronics, and Space Technology, partially offset by decreased margins at Ships, Integrated Systems, and Information Technology.

 

Operating margin consists of the following:

 

     Three months ended
March 31


 
$ in millions        2006             2005      

Segment operating margin

   $ 644     $ 638  

Unallocated expenses

     (35 )     (27 )

Net pension expense adjustment

     (10 )     (11 )

Reversal of royalty income

     (4 )     (5 )
   

Total operating margin

   $ 595     $ 595  
   

 

Unallocated Expenses – Unallocated expenses for the three months ended March 31, 2006, increased $8 million, or 30 percent, as compared with the same period in 2005. The increase was due primarily to timing of unrecoverable corporate costs.

 

Net Pension Expense Adjustment – The net pension expense adjustment reflects the excess pension expense determined in accordance with accounting principles generally accepted in the United States of America over the pension expense included in segment cost of sales to the extent that these costs are currently recognized under U.S. Government Cost Accounting Standards (CAS). The net pension expense adjustment for the three months ended March 31, 2006, was comparable to the same period in 2005.

 

Reversal of Royalty Income – Royalty income is included in segment operating margin for internal reporting purposes. For external reporting purposes, royalty income is reclassified to the “Other, net” line item discussed below.

 

Interest Expense

Interest expense for the three months ended March 31, 2006, decreased $5 million, or 5 percent, as compared with the same period in 2005. The decrease was primarily due to lower average debt outstanding in the most recent period.

 

Other, Net

Other, net for the three months ended March 31, 2006, decreased $83 million, or 101 percent, as compared with the same period in 2005. The decrease was primarily due to the pre-tax gain of $70 million recognized from the sale of TRW Auto shares in the first quarter of 2005.

 

Federal and Foreign Income Taxes

The company’s effective tax rate on income from continuing operations for the three months ended March 31, 2006, was 30.9 percent as compared with 33.2 percent for the same period in 2005. During the three months

 

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ended March 31, 2006, the company recognized a net tax benefit of $18 million with respect to tax credits associated with qualified wages paid to employees affected by Hurricane Katrina.

 

Discontinued Operations

Discontinued operations for the three months ended March 31, 2006, is comprised of a $5 million after-tax gain on the divestiture of the assembly business of Interconnect Technologies (Interconnect). See Note 3 to the Consolidated Condensed Financial Statements in Part I, Item 1. Discontinued operations for the three months ended March 31, 2005, is comprised of an $11 million after-tax gain on the divestiture of Teldix GmbH (Teldix).

 

Diluted Earnings Per Share from Continuing Operations

Diluted earnings per share for the three months ended March 31, 2006, was $1.02 per share, as compared with $1.08 per share in the same period in 2005. Earnings per share are based on weighted average diluted shares outstanding of 350.8 million for the three months ended March 31, 2006, and 367 million for the same period in 2005.

 

Net Cash (Used in) Provided by Operating Activities

For the three months ended March 31, 2006, the company used net cash in operating activities of $115 million compared to net cash provided of $263 million for the three months ended March 31, 2005. The decrease was primarily due to growth in accounts receivable during the quarter.

 

SEGMENT OPERATING RESULTS

 

For presentation and discussion purposes, the company’s seven reportable segments are categorized into four primary businesses. The Mission Systems, Information Technology and Technical Services segments are presented as Information & Services. The Integrated Systems and Space Technology segments are presented as Aerospace. The Electronics and Ships segments are presented as separate businesses. The Ships segment includes the aggregated results of the Newport News and Ship Systems operating segments.

 

Effective January 1, 2006, in order to provide a more relevant depiction of the management and performance of the company’s businesses, sales and segment operating margin in the following tables were revised to include margin on intersegment sales for all periods presented. Intersegment amounts are then eliminated upon consolidation of the segments.

 

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     Three months ended
March 31


 
$ in millions        2006             2005      

Sales and Service Revenues

                

Information & Services

                

Mission Systems

   $ 1,264     $ 1,254  

Information Technology

     1,057       1,034  

Technical Services

     275       274  
   

Total Information & Services

     2,596       2,562  

Aerospace

                

Integrated Systems

     1,437       1,287  

Space Technology

     855       863  
   

Total Aerospace

     2,292       2,150  

Electronics

     1,509       1,547  

Ships

     1,133       1,514  

Other

             11  

Intersegment eliminations

     (346 )     (331 )
   

Total sales and service revenues

   $ 7,184     $ 7,453  
   

Operating Margin

                

Information & Services

                

Mission Systems

   $ 117     $ 93  

Information Technology

     75       76  

Technical Services

     13       12  
   

Total Information & Services

     205       181  

Aerospace

                

Integrated Systems

     149       142  

Space Technology

     71       67  
   

Total Aerospace

     220       209  

Electronics

     177       162  

Ships

     68       107  

Other

             (1 )

Intersegment eliminations

     (26 )     (20 )
   

Total segment operating margin

   $ 644     $ 638  
   

 

Effective January 1, 2006, the company established a new reportable segment, Technical Services, to leverage existing business strengths and synergies in the rapidly expanding areas of logistics support, sustainment and technical services. Technical Services consolidates multiple programs in logistics operations from the Electronics (formerly Electronic Systems), Integrated Systems, Mission Systems and Information Technology segments.

 

Effective January 1, 2006, certain business areas within the Electronics and Information Technology segments were realigned and some business areas have been renamed. Where applicable, all comparisons to prior period information reflect these realignments and references to business areas in the discussion below reflect the new names.

 

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Segment operating results are discussed below with respect to the following financial measures:

 

Contract Acquisitions – Contract acquisitions represent orders received during the period for which funding has been contractually obligated by the customer. Contract acquisitions tend to fluctuate from year to year and are determined by the size and timing of new and follow-on orders. In the year that a business is purchased or divested, its existing funded order backlog as of the date of purchase or disposition is reported as an increase or decrease, respectively, to contract acquisitions.

 

Sales and Service Revenues – Year-to-year sales vary less than contract acquisitions and reflect performance under new and ongoing contracts.

 

Segment Operating Margin – Segment operating margin reflects the performance of segment contracts and programs. Excluded from this measure are certain costs not directly associated with contract performance, including the portion of pension expense/income that is not currently recognized under CAS, as well as the portion of corporate, legal, environmental, state income tax, other retiree benefits, and other expenses not considered allowable costs under CAS and therefore not allocated to the segments.

 

Contract Acquisitions, Sales and Service Revenues, and Segment Operating Margin in the tables within this section include intercompany amounts that are eliminated in the accompanying Consolidated Condensed Financial Statements.

 

INFORMATION & SERVICES

 

Mission Systems

Mission Systems is a leading global system integrator of complex, mission-enabling systems for government, military, and commercial customers. Products and services are focused in the following business areas: Command, Control & Intelligence Systems; Missile Systems; and Technical & Management Services.

 

     Three months ended
March 31


 
$ in millions        2006             2005      

Contract Acquisitions

   $ 1,728     $ 1,229  

Sales and Service Revenues

     1,264       1,254  

Segment Operating Margin

     117       93  

As a percentage of segment sales

     9.3 %     7.4 %

 

Contract Acquisitions

Mission Systems contract acquisitions for the three months ended March 31, 2006, increased $499 million, or 41 percent, as compared with the same period in 2005, partially due to the receipt of delayed funding upon the approval of the federal defense budget. Significant acquisitions during the three months ended March 31, 2006, included $413 million for the Intercontinental Ballistic Missile (ICBM) program, $92 million for the Joint National Integration Center Research & Development Contract, $51 million for the Kinetic Energy Interceptor program, and $59 million for the Command Post Program.

 

Sales and Service Revenues

Mission Systems sales for the three months ended March 31, 2006, increased $10 million, or 1 percent, as compared with the same period in 2005. The increase was primarily due to higher sales in Command, Control & Intelligence Systems, partially offset by lower sales in Missile Systems. Command, Control & Intelligence Systems revenue increased $28 million due to increased volume on several programs. Missile Systems revenue decreased $18 million primarily due to lower volume on the ICBM program.

 

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Segment Operating Margin

Mission Systems operating margin for the three months ended March 31, 2006, increased $24 million, or 26 percent, as compared with the same period in 2005. The increase was primarily due to favorable performance on the ICBM program in Missile Systems and on several programs in Command, Control & Intelligence Systems, and lower amortization expense for purchased intangibles.

 

Information Technology

Information Technology is a premier provider of advanced information technology (IT) solutions, engineering, and business services for government and commercial customers. Products and services are focused in the following business areas: Intelligence; Civilian Agencies; Commercial, State & Local; and Defense.

 

     Three months ended
March 31


 
$ in millions        2006              2005      

Contract Acquisitions

   $ 1,278      $ 1,103  

Sales and Service Revenues

     1,057        1,034  

Segment Operating Margin

     75        76  

As a percentage of segment sales

     7.1 %      7.4 %

 

Contract Acquisitions

Information Technology contract acquisitions for the three months ended March 31, 2006, increased $175 million, or 16 percent, as compared with the same period in 2005. Significant acquisitions during the three months ended March 31, 2006, included $77 million for the Enterprise Engineering program, $66 million for the Identification 1 program, $56 million for the Treasury Communications System program, and $47 million for the San Diego IT Outsourcing program.

 

Sales and Service Revenues

Information Technology sales for the three months ended March 31, 2006, increased $23 million, or 2 percent, as compared with the same period in 2005. The increase was primarily due to higher sales in Defense, Civilian Agencies, and Intelligence, partially offset by lower sales in Commercial, State & Local. Defense revenue increased $36 million due to new programs, most notably the United Kingdom Whole Life Support Programme, and higher volume in existing programs. Civilian Agencies revenue increased $26 million primarily due to the acquisition of Integic in March 2005. Intelligence revenue increased $14 million due to higher volume in existing programs. Commercial, State & Local revenue decreased $66 million which includes a $53 million decrease in the value-added reseller business. In the first quarter of 2006, the company announced that it would exit the reseller business and expects to close this operation by the end of 2006. The results of operations of this business will be reclassified to discontinued operations in the period in which it is shut down.

 

Segment Operating Margin

Information Technology operating margin for the three months ended March 31, 2006, was essentially unchanged as compared with the same period in 2005. The results of operations of the value-added reseller business will be reclassified to discontinued operations in the period in which it is shut down.

 

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Technical Services

Technical Services is a leading provider of logistics, infrastructure, and sustainment support, while also providing a wide-array of technical services including training and simulation.

 

     Three months ended
March 31


 
$ in millions    2006      2005  

Contract Acquisitions

   $ 451      $ 270  

Sales and Service Revenues

     275        274  

Segment Operating Margin

     13        12  

As a percentage of segment sales

     4.7 %      4.4 %

 

Contract Acquisitions

Technical Services contract acquisitions for the three months ended March 31, 2006, increased $181 million, or 67 percent, as compared with the same period in 2005. Significant acquisitions during the three months ended March 31, 2006, included $172 million for the Joint Base Operations Support (JBOSC) program, $41 million for the Fort Irwin program, and additional funding of $21 million for the Citizenship and Immigration Services (CIS) program.

 

Sales and Service Revenues

Technical Services sales for the three months ended March 31, 2006, was essentially unchanged as compared with the same period in 2005.

 

Segment Operating Margin

Technical Services operating margin for the three months ended March 31, 2006, was essentially unchanged as compared with the same period in 2005.

 

AEROSPACE

 

Integrated Systems

Integrated Systems is a leader in the design, development, and production of airborne early warning, electronic warfare and surveillance, and battlefield management systems, as well as manned and unmanned tactical and strike systems. Products and services are focused in the following business areas: Integrated Systems Western Region, Airborne Early Warning & Electronic Warfare Systems, and Airborne Ground Surveillance & Battle Management Systems.

 

     Three months ended
March 31


 
$ in millions        2006             2005      

Contract Acquisitions

   $ 2,735     $ 1,926  

Sales and Service Revenues

     1,437       1,287  

Segment Operating Margin

     149       142  

As a percentage of segment sales

     10.4 %     11.0 %

 

Contract Acquisitions

Integrated Systems contract acquisitions for the three months ended March 31, 2006, increased $809 million, or 42 percent, as compared with the same period in 2005, partially due to the receipt of delayed funding upon the approval of the federal defense budget. Significant acquisitions during the three months ended March 31, 2006, included $707 million related to the F/A-18 program, $609 million related to the E-2C Advanced Hawkeye program, $311 million related to the F-35 program, and $208 million related to the B-2 program.

 

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Sales and Service Revenues

Integrated Systems sales for the three months ended March 31, 2006, increased $150 million, or 12 percent, as compared with the same period in 2005. The increase resulted from higher sales in Airborne Early Warning & Electronic Warfare Systems and Integrated Systems Western Region. Airborne Early Warning & Electronic Warfare Systems revenue increased $75 million primarily due to higher volume in the E-2C Advanced Hawkeye and E-2 Post Multi-Year Procurement programs. Integrated Systems Western Region revenue increased $73 million primarily due to higher volume in the F/A-18 and F-35 programs.

 

Segment Operating Margin

Integrated Systems operating margin for the three months ended March 31, 2006, increased $7 million, or 5 percent, as compared with the same period in 2005. The increase was primarily due to increased volume in Airborne Early Warning & Electronic Warfare Systems and Integrated Systems Western Region. The decrease in operating margin as a percentage of sales reflects an increased proportion of lower margin development programs including F-35, HALE Systems (Global Hawk), E-2C Advanced Hawkeye, and E-10A.

 

Space Technology

Space Technology develops and integrates a broad range of systems at the leading edge of space, defense, and electronics technology, including the design, development, manufacture, and integration of spacecraft systems and subsystems, electronic and communications payloads, advanced avionics systems, and high energy laser systems and subsystems. Products and services are focused in the following business areas: Intelligence, Surveillance & Reconnaissance; Civil Space; Satellite Communications; Software Defined Radios; Missile & Space Defense; and Technology.

 

     Three months ended
March 31


 
$ in millions        2006             2005      

Contract Acquisitions

   $ 1,641     $ 873  

Sales and Service Revenues

     855       863  

Segment Operating Margin

     71       67  

As a percentage of segment sales

     8.3 %     7.8 %

 

Contract Acquisitions

Space Technology contract acquisitions for the three months ended March 31, 2006, increased $768 million, or 88 percent, as compared with the same period in 2005, partially due to the receipt of delayed funding upon the approval of the federal defense budget. Significant acquisitions during the three months ended March 31, 2006, included $482 million for restricted programs, $342 million for the Advanced Extremely High Frequency program, and additional funding of $304 million for the National Polar-orbiting Operational Environmental Satellite System (NPOESS) program.

 

Sales and Service Revenues

Space Technology sales for the three months ended March 31, 2006, decreased $8 million, or 1 percent, as compared with the same period in 2005. The decrease was primarily due to lower sales in Missile & Space Defense, Civil Space, and Software Defined Radios. Missile & Space Defense revenue decreased $21 million, due to the wind down of the Mobile Tactical High Energy Laser program, which was partially offset by increased sales for the Airborne Laser program. Civil Space revenue decreased $13 million, due to lower sales in the NPOESS and James Webb Space Telescope programs. Software Defined Radios decreased $13 million, due to lower sales for the Joint Strike Fighter and NextGen programs. These sales decreases were partially offset by higher volume in the Advanced Extremely High Frequency program in Satellite Communications.

 

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Segment Operating Margin

Space Technology operating margin for the three months ended March 31, 2006, increased $4 million, or 6 percent, as compared with the same period in 2005. The increase was primarily due to performance improvements in Satellite Communications and Missile & Space Defense.

 

ELECTRONICS

 

Electronics is a leading designer, developer, manufacturer and integrator of a variety of advanced electronic and maritime systems for national security and select non-defense applications. Products and services are focused in the following business areas: Aerospace Systems, Defensive Systems, Navigation Systems, Government Systems, Naval & Marine Systems, and Defense Other.

 

     Three months ended
March 31


 
$ in millions        2006             2005      

Contract Acquisitions

   $ 1,846     $ 1,670  

Sales and Service Revenues

     1,509       1,547  

Segment Operating Margin

     177       162  

As a percentage of segment sales

     11.7 %     10.5 %

 

Contract Acquisitions

Electronics contract acquisitions for the three months ended March 31, 2006, increased $176 million, or 11 percent, as compared with the same period in 2005, partially due to the receipt of delayed funding upon the approval of the federal defense budget. Significant acquisitions during the three months ended March 31, 2006, included $111 million for the MP-RTIP Phase II program, $104 million for the Virginia-class program, and $89 million for the SBIRS program.

 

Sales and Service Revenues

Electronics sales for the three months ended March 31, 2006, decreased $38 million, or 2 percent, as compared with the same period in 2005. The decrease was primarily due to lower sales in Aerospace Systems and Navigation Systems. Aerospace Systems revenue decreased $32 million due to lower volume on the F-16 Block 60 program as production winds down. Navigation Systems revenue decreased $31 million primarily resulting from the divestiture of Teldix in 2005. These decreases were partially offset by higher volume in Government Systems, which increased revenue by $26 million primarily due to Tactical Communications programs.

 

Segment Operating Margin

Electronics operating margin for the three months ended March 31, 2006, increased $15 million, or 9 percent, as compared with the same period in 2005. The increase was primarily due to performance improvements in several programs in Defensive Systems and Aerospace Systems, and lower amortization expense for purchased intangibles.

 

SHIPS

 

Ships is one of the nation’s leading full service providers for the design, engineering, construction, and life cycle support of major surface ships for the U.S. Navy, U.S. Coast Guard, international navies, and commercial vessels. Ships is also the nation’s sole industrial designer, builder, and refueler of nuclear-powered aircraft carriers and one of only two companies capable of designing and building nuclear-powered submarines. Products and services are focused in the following business areas: Aircraft Carriers, Expeditionary Warfare, Submarines, Surface Combatants, Coast Guard & Coastal Defense, Services, and Commercial & Other.

 

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     Three months ended
March 31


 
$ in millions        2006             2005      

Contract Acquisitions

   $ 3,054     $ 1,166  

Sales and Service Revenues

     1,133       1,514  

Segment Operating Margin

     68       107  

As a percentage of segment sales

     6.0 %     7.1 %

 

Contract Acquisitions

Ships contract acquisitions for the three months ended March 31, 2006, increased $1.9 billion, or 162 percent, as compared with the same period in 2005, partially due to the receipt of delayed funding upon the approval of the federal defense budget. Significant acquisitions during the three months ended March 31, 2006, included $1 billion for the USS Carl Vinson, $757 million for the Virginia-class Block II program, and additional funding of $450 million for the CVN21 program.

 

Sales and Service Revenues

Ships sales for the three months ended March 31, 2006, decreased $381 million, or 25 percent, as compared with the same period in 2005. The decrease was primarily due to lower sales in Surface Combatants and Expeditionary Warfare. Surface Combatants revenue decreased $276 million primarily due to lower volume in the DD(X) program. Sales in the LPD, LHD, DDG, and Coast Guard Deepwater programs were impacted by hurricane-related work delays.

 

Segment Operating Margin

Ships operating margin for the three months ended March 31, 2006, decreased $39 million, or 36 percent, as compared with the same period in 2005, primarily due to decreased sales volume in Surface Combatants and Expeditionary Warfare, and reduced margin rates in the LPD, LHD, DDG, and Coast Guard Deepwater programs as a result of hurricane-related work delays and cost growth.

 

BACKLOG

 

Total backlog at March 31, 2006, was approximately $58 billion. Total backlog includes both funded backlog (unfilled orders for which funding is contractually obligated by the customer) and unfunded backlog (firm orders for which funding is not currently contractually obligated by the customer). Unfunded backlog excludes unexercised contract options and unfunded Indefinite Delivery/Indefinite Quantity orders. Backlog is converted into sales as work is performed or deliveries are made.

 

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The following table presents funded, unfunded, and total backlog by segment at March 31, 2006.

 

     March 31, 2006

 
$ in millions    Funded     Unfunded    Total
Backlog
 

Information & Services

                       

Mission Systems

   $ 2,940     $ 7,706    $ 10,646  

Information Technology

     2,631       2,326      4,957  

Technical Services

     552       868      1,420  
   

Total Information & Services

     6,123       10,900      17,023  

Aerospace

                       

Integrated Systems

     5,043       6,408      11,451  

Space Technology

     1,785       8,668      10,453  
   

Total Aerospace

     6,828       15,076      21,904  

Electronics

     6,694       1,803      8,497  

Ships

     8,050       3,065      11,115  

Other

                       

Intersegment eliminations

     (531 )            (531 )
   

Total

   $ 27,164     $ 30,844    $ 58,008  
   

 

Major components in unfunded backlog as of March 31, 2006, included various restricted programs across all operating segments, the Kinetic Energy Interceptor program in the Mission Systems segment; the F-35 and F/A-18 programs in the Integrated Systems segment; the NPOESS program in the Space Technology segment; and Block II of the Virginia-class submarines program in the Ships segment.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Operating Activities – Net cash used in operating activities for the three months ended March 31, 2006, was $115 million compared to net cash provided of $263 million for the same period of 2005. The decrease was primarily due to growth in accounts receivable during the quarter. Net cash from operating activities for the three months ended March 31, 2005, included a payment of $99 million for a litigation settlement.

 

For 2006, cash generated from operations supplemented by borrowings under credit facilities is expected to be sufficient to service debt and contract obligations, finance capital expenditures, complete the share repurchase program, and continue paying dividends to the company’s shareholders.

 

Investing Activities – Net cash used in investing activities for the three months ended March 31, 2006, was $143 million compared to $310 million in the same period of 2005. During the first quarter of 2006, the company received net proceeds of $26 million from the sale of the assembly business of Interconnect and $37 million of insurance proceeds related to Hurricane Katrina. During the three months ended March 31, 2005, the company acquired Integic for $313 million, sold 7.3 million common shares of TRW Auto for $143 million, and sold Teldix for $56 million.

 

Financing Activities – Net cash used in financing activities for the three months ended March 31, 2006, was $1 billion compared to $399 million in the same period of 2005. Net cash from financing activities for the three months ended March 31, 2006, included payments of $436 million related to maturities of long-term debt. During the three months ended March 31, 2006 and 2005, the company paid approximately $787 million and $360 million under common stock repurchase programs, respectively. See Note 5 to the Consolidated Condensed

 

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Financial Statements in Part I, Item 1. During the three months ended March 31, 2006, the company received cash of $286 million from the exercise of stock options.

 

NEW ACCOUNTING STANDARDS

 

None of the new accounting pronouncements that became effective during the periods presented had a material effect on the company’s financial position or results of operations. The expanded disclosure requirements of Statement of Financial Accounting Standards No. 123R – Share-Based Payment (SFAS No. 123R) are presented in Note 12.

 

FORWARD-LOOKING INFORMATION

 

Statements in this Form 10-Q that are in the future tense, and all statements accompanied by terms such as “believe,” “project,” “expect,” “estimate,” “assume,” “intend,” “anticipate,” and variations thereof and similar terms are intended to be “forward-looking statements” as defined by federal securities law. Forward-looking statements are based upon assumptions, expectations, plans and projections that are believed valid when made, but that are subject to the risks and uncertainties identified under Risk Factors in the company’s 2005 Annual Report on Form 10-K as amended or supplemented by the information in Part II, Item 1A below, that may cause actual results to differ materially from those expressed or implied in the forward-looking statements.

 

The company intends that all forward-looking statements made will be subject to safe harbor protection of the federal securities laws pursuant to Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

 

Forward-looking statements are based upon, among other things, the company’s 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;
    hurricane-related insurance recoveries;
    environmental remediation;
    divestitures of businesses;
    successful reduction of debt;
    performance issues with key suppliers and subcontractors;
    product performance and the successful execution of internal plans;
    successful negotiation of contracts with labor unions;
    effective tax rates and timing and amounts of tax payments;
    the results of any audit or appeal process with the Internal Revenue Service; and
    anticipated costs of capital investments.

 

You should consider the limitations on, and risks associated with, forward-looking statements and not unduly rely on the accuracy of predictions contained in such forward-looking statements. As noted above, these forward-looking statements speak only as of the date when they are made. The company does not undertake any obligation to update forward-looking statements to reflect events, circumstances, changes in expectations, or the occurrence of unanticipated events after the date of those statements. Moreover, in the future, the company, through senior management, may make forward-looking statements that involve the risk factors and other matters described in this Form 10-Q as well as other risk factors subsequently identified, including, among others, those identified in the company’s filings with the Securities and Exchange Commission on Form 10-K and Form 8-K.

 

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Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

Interest Rates – 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 agreement, and short-term investments. At March 31, 2006, substantially all borrowings were fixed-rate long-term debt obligations, none of which are callable until maturity (other than make-whole calls). The company’s sensitivity to a 1 percent change in interest rates is tied primarily to its $2 billion credit agreement, which had no balance outstanding at March 31, 2006.

 

The company may enter into interest rate swap agreements to manage its exposure to interest rate fluctuations. The company does not hold or issue derivative financial instruments for trading purposes. At March 31, 2006, two interest rate swap agreements were in effect but were not material.

 

Foreign Currency – 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. At March 31, 2006, the amount of foreign currency forward contracts outstanding was not material. The market risk exposure relating to foreign currency exchange is not material to the consolidated financial statements.

 

Accelerated Stock Repurchase – The company is subject to equity price risk due to the repurchase of common stock through its accelerated stock repurchase program (see Part II, Item 2). At the end of the program, the company is required to receive or pay a price adjustment based on the difference between the average price paid by Credit Suisse, New York Branch (Credit Suisse) for the company’s stock over the life of the program and the initial purchase price of $64.78 per share. At the company’s election, any payments obligated pursuant to the settlement of the forward contract could either be in cash or in shares of the company’s common stock. Changes in the fair value of the company’s common stock will impact the final settlement of the program. Settlement is expected to occur in the second quarter of 2006, depending upon the timing and pace of open market purchases. Assuming Credit Suisse purchases the remaining shares at a price per share equal to the closing price of the company’s common stock on March 31, 2006 ($68.29), the company would be required to pay approximately $38.1 million (including related settlement fees, interest and expenses) or issue approximately 550,000 shares of common stock to complete the transaction.

 

Item 4.  Controls and Procedures

 

Disclosure Controls and Procedures

The company’s principal executive officer (Chairman, Chief Executive Officer and President) and principal financial officer (Corporate Vice President and Chief Financial Officer) have evaluated the company’s disclosure controls and procedures as of March 31, 2006, and have concluded that these controls and procedures are effective to ensure that information required to be disclosed by the company in the reports that it files or submits under the Securities Exchange Act of 1934 (15 USC § 78a et seq) is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. These disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the company in the reports that it files or submits is accumulated and communicated to management, including the principal executive officer and the principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

 

Changes in Internal Control Over Financial Reporting

During the three months ended March 31, 2006, no change occurred in the company’s internal control over financial reporting that materially affected, or is likely to materially affect, the company’s internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

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

 

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

 

At a briefing in October 2005, the U.S. Department of Justice and a classified U.S. Government customer apprised the company of potential substantial claims relating to certain microelectronic parts produced by the Space and Electronics Sector of former TRW Inc., now a component of the company. It is unclear whether the potential claims relate to a civil False Claims Act case that remains under seal in the U.S. District Court for the Central District of California. The company responded to the allegations, and the parties continue to meet to better understand the factual basis of the claims before the government decides whether to institute formal legal proceedings or to pursue some other form of resolution. Because of the highly technical nature of the issues involved and their classified status, final resolution of this matter could take a considerable amount of time, particularly if litigation should ensue. If the U.S. Department of Justice were to pursue litigation and were to be ultimately successful on its theories of liability and compensatory damages, the effect upon the company’s financial position, results of operations, and cash flows would be material. Based upon its review to date, the company believes that it acted appropriately in this matter but can give no assurance that its view will prevail. The company is not able to estimate the amount of damages, if any, at this time.

 

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

 

Item 1A.  Risk Factors

 

The following are new or modified risk factors that should be read in conjunction with the risk factors disclosed in the company’s 2005 Annual Report on Form 10-K:

 

The Company’s Insurance Coverage May Be Inadequate to Cover All of Its Significant Risks or Its Insurers May Deny Coverage of Material Losses Incurred by the Company, Which Could Adversely Affect the Company’s Profitability and Overall Financial Position.

 

The company endeavors to identify and obtain in established markets insurance agreements to cover significant risks and liabilities (including, among others, natural disasters, products liability and business interruption). Not every risk or liability can be protected against by insurance, and, for insurable risks, the limits of coverage reasonably obtainable in the market may not be sufficient to cover all actual losses or liabilities incurred. In such loss situations, the company may have to bear substantial costs that could have an adverse effect upon its

 

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consolidated results of operations and its overall consolidated financial position. Additionally, disputes with insurance carriers over coverage may affect the timing of cash flows and, where litigation with the carrier becomes necessary, an outcome unfavorable to the company may adversely affect the company’s consolidated results of operations. See Note 8 to the Consolidated Condensed Financial Statements in Part I, Item 1.

 

Pension and Medical Expense Associated with the Company’s Retirement Benefit Plans May Change Significantly Depending Upon Changes in Actuarial Assumptions, Future Market Performance of Plan Assets, and Changes in Regulations, and Such Changes Could Adversely Affect the Company’s Financial Position, Results of Operations, and Cash Flows.

 

A substantial portion of the company’s current and retired employee population is covered by pension and post-retirement obligation plans, the costs of which are dependent upon the company’s estimates of rates of return on benefit related assets, discount rates for future payment obligations, rates of future cost growth and trend rates for future costs. Variances from these estimates could adversely affect the company’s financial position and results of operations.

 

Certain of the company’s pension plans are under funded. The U.S. Congress is currently considering two separate bills designed to increase the amount by which companies fund their pension plans among other provisions. It is not possible to predict whether Congress will adopt pension reform legislation, or what form any final legislation might take. Should these bills become law in their current form, the company may be required to increase its pension funding obligations.

 

Current Trends in U.S. Government Procurement Methodology May Adversely Affect Cash Flows or Program Profitability.

 

The company, like others in the defense industry, is aware of a potential problem presented by strict compliance with the Defense Federal Acquisition Regulation Supplement preference for enumerated specialty metals sourced domestically or from certain foreign countries. Subcontractors and lower-tier suppliers have made disclosures indicating inability to comply with the rule as written, particularly for low-value parts such as washers, screws, nuts, bolts, resistors and capacitors. Inability to certify that all enumerated specialty metals in a product comply with sourcing requirements may lead to U.S. Government customers withholding a portion of a payment on delivery or may prevent delivery altogether of materiel and products critical to national defense.

 

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Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

 

Purchases of Equity Securities – The table below summarizes the company’s repurchases of common stock during the three months ended March 31, 2006.

 

Period    Total Number
of Shares
Purchased (1)
   Average Price
Paid per Share
   Total Number
of Shares
Purchased as
Part of
Publicly
Announced
Plans or
Programs
   Approximate
Dollar Value of
Shares that
May Yet Be
Purchased
Under the Plans
or Programs

January 1, 2006, through January 31, 2006

                    $ 1.0 billion

February 1, 2006, through February 28, 2006

                    $ 1.0 billion

March 1, 2006, through
March 31, 2006

   11,577,647    $ 64.78    11,577,647    $ 213 million
 

Total

   11,577,647    $ 64.78    11,577,647    $ 213 million
 

 

(1) On October 24, 2005, the company’s board of directors authorized a share repurchase program of up to $1.5 billion of its outstanding common stock, which commenced in November 2005 and is expected to be completed by the end of 2006.

 

Under this program, the company entered into an initial agreement with Credit Suisse, New York Branch (Credit Suisse) on November 4, 2005, to repurchase approximately 9.1 million shares of common stock at an initial price of $55.15 per share for a total of $500 million. Credit Suisse immediately borrowed shares that were sold to and canceled by the company. Subsequently, Credit Suisse purchased shares in the open market to settle its share borrowings. On March 1, 2006, Credit Suisse completed its purchases under this agreement, and the company paid $37 million for the final price adjustment under the terms of the agreement (which is deducted from the dollar value remaining under the program in the table above). The final average purchase price was $59.05 per share.

 

The company entered into a second agreement with Credit Suisse on March 6, 2006, to repurchase approximately 11.6 million shares of common stock at an initial price of $64.78 per share for a total of $750 million. Under this agreement, Credit Suisse immediately borrowed shares that were sold to and canceled by the company. Subsequently, Credit Suisse began purchasing shares in the open market to settle its share borrowings. The company’s initial share repurchase is subject to adjustment based on the actual cost of the shares subsequently purchased by Credit Suisse. The price adjustment can be settled, at the company’s option, in cash or in shares of common stock.

 

As of March 31, 2006, Credit Suisse had purchased 3.8 million shares, or 33 percent of the shares under the agreement, at an average price per share of $68.30 net of commissions, interest and other fees. Assuming Credit Suisse purchases the remaining shares at a price per share equal to the closing price of the company’s common stock on March 31, 2006 ($68.29), the company would be required to pay approximately $38.1 million or issue approximately 550,000 shares of common stock 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 second quarter of 2006, depending upon the timing and pace of the purchases, and would result in an adjustment to shareholders’ equity.

 

Share repurchases take place at management’s discretion and under pre-established non-discretionary programs from time to time, depending on market conditions, in the open market, and in privately negotiated transactions. The company retires its common stock upon repurchase and has not made any purchases of common stock other than in connection with these publicly announced repurchase programs.

 

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Item 3.  Defaults Upon Senior Securities

 

No information is required in response to this item.

 

Item 4.  Submission of Matters to a Vote of Security Holders

 

No information is required in response to this item.

 

Item 5.  Other Information

 

No information is required in response to this item.

 

Item 6.  Exhibits

 

10.1    Accelerated Share Repurchase Agreement, dated as of March 6, 2006, between Credit Suisse, New York Branch, and Northrop Grumman Corporation (incorporated by reference to Exhibit 10.1 to Form 8-K dated March 6, 2006 and filed March 7, 2006)
*10.2    Northrop Grumman 2006 Annual Incentive Plan and Incentive Compensation Plan (for Non-Section 162(m) Officers)
10.3    Authorization of base salary adjustments (effective December 31, 2005 for Named Executive Officers (“NEOs”), as defined by Item 402(a)(3) of SEC Regulation S-K, of Northrop Grumman Corporation), approval of cash bonus compensation for 2005 for NEOs; and approval of 2006 goals under the 2002 Incentive Compensation Plan (incorporated by reference to Item 1.01 of Form 8-K dated February 15, 2006 and filed February 17, 2006)
*15    Letter from independent registered public accounting firm regarding unaudited interim financial information
*31.1    Rule 13a-14(a)/15d-14(a) Certification of Ronald D. Sugar (Section 302 of the Sarbanes-Oxley Act of 2002)
*31.2    Rule 13a-14(a)/15d-14(a) Certification of Wesley G. Bush (Section 302 of the Sarbanes-Oxley Act of 2002)
**32.1    Certification of Ronald D. Sugar pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
**32.2    Certification of Wesley G. Bush pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

* Filed with this Report
** Furnished with this Report

 

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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 GRUMMAN CORPORATION
        (Registrant)
Date: April 24, 2006       By:   /S/    KENNETH N. HEINTZ        
           

Kenneth N. Heintz

Corporate Vice President, Controller and

Chief Accounting Officer

(Principal Accounting Officer)

 

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