UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

Commission File Number

1-16411

 

NORTHROP GRUMMAN CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

1840 Century Park East, Los Angeles, California 90067

www.northropgrumman.com

(Address of principal executive offices and internet site)

 

(310) 553-6262

(registrant’s telephone number, including area code)

 

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

 

 

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

Large accelerated filer x           Accelerated filer o          Non-accelerated filer o

 

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

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

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

 

As of October 20, 2006, 345,412,605 shares of common stock were outstanding.

 

 

NORTHROP GRUMMAN CORPORATION

 

Table of Contents

 

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

 

NORTHROP GRUMMAN CORPORATION

 

 

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

 

NORTHROP GRUMMAN CORPORATION

 

 

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

 

NORTHROP GRUMMAN CORPORATION

 

 

NORTHROP GRUMMAN CORPORATION

 

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

 

NORTHROP GRUMMAN CORPORATION

 

 

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

 

NORTHROP GRUMMAN CORPORATION

 

 

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

 

The accompanying unaudited consolidated condensed financial statements of the company have been prepared by management in accordance with the instructions to Form 10-Q of the Securities and Exchange Commission. These statements include all adjustments considered necessary by management to present a fair statement of the consolidated 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 (GAAP). The preparation of the financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of 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 – As a result of the items discussed below, certain amounts in the prior period 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, Technical Services, to leverage existing business strengths and synergies in the rapidly expanding areas of logistics support, sustainment and technical services. The Technical Services segment was established through the consolidation of multiple programs in logistics operations from the Electronics, Integrated Systems, Mission Systems and Information Technology segments. On July 1, 2006, additional programs from Electronics, Integrated Systems, Mission Systems, and Space Technology were transferred to Technical Services. The sales and segment operating margin in Note 6 have been revised, where material, to reflect these realignments for all periods presented.

 

During the second quarter of 2006, the company completed the shut down of the Enterprise Information Technology business formerly reported as part of the Information Technology segment. The assets, liabilities, and results of operations of this business have been reclassified from continuing operations to discontinued operations for all periods presented (See Note 5).

 

 

There was no material effect on the company’s consolidated financial position or results of operations due to new accounting pronouncements that became effective during the periods presented. The expanded disclosure requirements of Statement of Financial Accounting Standards (SFAS) No. 123R – Share-Based Payment are presented in Note 14.

 

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Other new pronouncements which are not effective until after September 30, 2006, are not expected to have a significant effect on the company’s consolidated financial position or results of operations, with the possible exception of the following, which are currently being evaluated by management:

 

In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 158 – Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R). SFAS No. 158 requires an employer to recognize the funded status of defined benefit pension and other postretirement benefit plans as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through other comprehensive income in shareholders’ equity. The company is required to initially recognize the funded status of its defined benefit pension and other postretirement benefit plans and to provide the required disclosures as of December 31, 2006. Although management continues to evaluate the effect that the recognition of the funded status of its plans will have on the company’s consolidated financial position, the company estimates the adoption will increase accumulated other comprehensive loss, a component of shareholders’ equity, by a net after-tax amount of approximately $2.7 billion, based on our current assumptions of discount rate and return on plan assets. The company already complies with the requirement under the statement to measure plan assets and benefit obligations as of the employer’s fiscal year end. Adoption of this statement is not expected to have a material impact on the company’s consolidated results of operations.

 

In September 2006, the FASB issued SFAS No. 157 – Fair Value Measurements, which defines fair value, establishes a framework for consistently measuring fair value under GAAP, and expands disclosures about fair value measurements. SFAS No. 157 is effective for the company beginning January 1, 2008, and the provisions of SFAS No. 157 will be applied prospectively as of that date. Management is currently evaluating the effect that adoption of this statement will have on the company’s consolidated financial position and results of operations when it becomes effective in 2008.

 

In June 2006, the FASB issued FASB Interpretation No. (FIN) 48 – Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109. FIN 48 prescribes a threshold for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Only tax positions meeting the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of this Interpretation. FIN 48 also provides guidance on accounting for derecognition, interest and penalties, and classification and disclosure of matters related to uncertainty in income taxes. FIN 48 will be effective for the company January 1, 2007, and will require adjustment to the opening balance of retained earnings (or other components of shareholders’ equity in the statement of financial position) for the cumulative effect of the difference in the net amount of assets and liabilities for all open tax positions at the effective date. Management is currently evaluating the effect that adoption of this interpretation will have on the company’s consolidated financial position and results of operations.

 

 

Common Stock Dividend – On May 17, 2006, the company’s board of directors approved a 15 percent increase to the quarterly common stock dividend, from $.26 per share to $.30 per share, effective with the second quarter 2006 dividend. On March 23, 2005, the company’s Board of Directors approved a 13 percent increase to the quarterly common stock dividend, from $.23 per share to $.26 per share, effective with the second quarter 2005 dividend.

 

 

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 and is reported in the Information Technology segment. The assets, liabilities, and results of operations of Integic were not material and thus pro-forma information is not presented.

 

Confluent – On September 30, 2005, the company acquired privately held Confluent RF Systems Corporation (Confluent) for $42 million, which includes estimated transaction costs of $2 million. In addition, the company

 

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paid $10 million into an escrow account to retain the services of a key employee for a twelve-month period. Of this amount, $2.5 million was recognized as compensation expense in 2005, and as of December 31, 2005, $7.5 million remained in “Prepaid expenses and other current assets” in the accompanying Consolidated Condensed Statements of Financial Position. This remaining amount was recognized as compensation expense in the nine months ended September 30, 2006. The acquisition of Confluent provides the company with access to a unique set of proprietary technologies for use on various programs. The operating results of this business are reported in the Integrated Systems segment. The assets, liabilities, and results of operations of the acquired business were not material and thus pro-forma information is not presented.

 

 

Enterprise Information Technology – In January 2006, management announced its decision to exit the value-added reseller business reported within the Information Technology segment as the Enterprise Information Technology (EIT) business area. The shutdown of this business was completed during the second quarter of 2006 and costs associated with the shut down were not material. The results of operations of this business are reported as discontinued operations in the consolidated condensed statements of income, net of applicable income taxes, for all periods presented.

 

Winchester – On June 23, 2006, the company sold Winchester Electronics (Winchester) for net cash proceeds of $17 million and recognized an after-tax gain of $2 million in discontinued operations. The results of operations of Winchester, reported in the Electronics segment, were not material to any of the periods presented and have therefore not been reclassified as discontinued operations.

 

Interconnect – On February 24, 2006, the company sold the assembly business of Interconnect Technologies (Interconnect) for net cash proceeds of $26 million and recognized an after-tax gain of $5 million in discontinued operations. Subsequent purchase price adjustments pursuant to the sale agreement decreased the after-tax gain to $4 million for the nine months ended September 30, 2006. 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.

 

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 adjustments 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.

 

Sales and operating results of the EIT business and the gains from divestitures of other businesses classified within discontinued operations for the three and nine months ended September 30, 2006, and 2005, respectively, were as follows:

 

 

NORTHROP GRUMMAN CORPORATION

The assets and liabilities of the EIT business, as shown in the table below, are not material and have been collapsed into “Prepaid expenses and other current assets” and “Other current liabilities,” respectively, in the accompanying Consolidated Condensed Statements of Financial Position.

 

 

 

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. The Technical Services segment was established through the consolidation of multiple programs in logistics operations from the Electronics, Integrated Systems, Mission Systems and Information Technology segments. On July 1, 2006, additional programs from Electronics, Integrated Systems, Mission Systems, and Space Technology were transferred to Technical Services. The sales and segment operating margin in the following tables have been revised, where material, to reflect these realignments for all periods presented.

 

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.

 

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 Newport News and Ship Systems.

 

NORTHROP GRUMMAN CORPORATION

The following table presents segment sales and service revenues for the three and nine months ended September 30, 2006, and 2005.

 

 

NORTHROP GRUMMAN CORPORATION

The following table presents segment operating margin reconciled to total operating margin for the three and nine months ended September 30, 2006, and 2005.

 

 

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 United States (U.S.) Government Cost Accounting Standards (CAS) regulations and the Federal Acquisition Regulation, and therefore not allocated to the segments.

 

Net Pension Expense – Net pension expense reflects pension expense determined in accordance with GAAP less the pension expense included in segment cost of sales to the extent that these costs are currently recognized under CAS. For the three months ended September 30, 2006, and 2005, pension expense determined in accordance with GAAP was $112 million and $102 million, respectively, offset by pension expense under CAS of $110 million and $98 million, respectively. For the nine months ended September 30, 2006 and 2005, pension expense determined in accordance with GAAP was $337 million and $308 million, respectively, offset by pension expense under CAS of $313 million and $295 million, respectively.

 

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 in the Consolidated Condensed Statements of Income.

 

 

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.

 

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Diluted Earnings Per Share – The dilutive effect of stock options and other stock awards granted to employees under stock-based compensation plans totaled 6.3 million shares for both the three and nine months ended September 30, 2006, and 6.0 million shares and 6.2 million shares for the three and nine months ended September 30, 2005, respectively. 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 also exclude shares issuable under 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 shares excluded was approximately 8 thousand and 32 thousand for the three and nine months ended September 30, 2006, respectively, and approximately 4 million for the three and nine months ended September 30, 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 under which $176 million is remaining.

 

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 purchased shares in the open market to settle its share borrowings. On May 26, 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 $68.01 per share.

 

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.

 

 

TRW Auto – On March 11, 2005, the company sold 7.3 million of its TRW Automotive Holdings Corp. (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 “Other assets” as of September 30, 2006, and December 31, 2005. The company does not consider this investment to be critical to its ongoing business operations. Sale of this investment is subject to restrictions described in the Second Amended and Restated Stockholders Agreement dated January 28, 2004, between the company and TRW Auto.

 

Endwave – During the third quarter of 2005, the company sold 2.1 million shares of Endwave Corporation (Endwave) for $81 million, and recorded an after-tax gain of $53 million. These sales reduced the company’s ownership of Endwave to 1.3 million common shares as of September 30, 2005. The company’s remaining investment was sold prior to December 31, 2005, and therefore is not included in the accompanying Consolidated Condensed Statements of Financial Position.

 

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Goodwill

Effective January 1, 2006, the company realigned businesses among four of its operating segments to form a new segment called Technical Services. On July 1, 2006, additional programs were transferred to the Technical Services segment. As a result of these realignments, goodwill of approximately $792 million was reallocated among the affected segments. The changes in the carrying amounts of goodwill for the nine months ended September 30, 2006, were as follows:

 

 

Fair Value Adjustments to Net Assets Acquired – The fair value adjustments were primarily due to the resolution of pre-acquisition tax uncertainties resulting from the completion of audits by the Internal Revenue Service.

 

Purchased Intangible Assets

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

 

 

The company’s purchased intangible assets are subject to amortization and are being amortized on a straight-line basis over an aggregate weighted-average period of 22 years. Aggregate amortization expense for the three and nine months ended September 30, 2006, was $31 million and $104 million, respectively.

 

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

 

 

NORTHROP GRUMMAN CORPORATION

 

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 September 30, 2006, management estimates that the costs to clean-up and restore its operations will total approximately $850 million, which includes $590 million estimated to repair or replace assets damaged by the storm. Substantially all of the estimated cost is expected to be recovered through the company’s comprehensive property damage insurance. As of September 30, 2006, the company had received $264 million in insurance proceeds, of which $31 million was received during the three months ended September 30, 2006.

 

Through September 30, 2006, the company has expended $348 million in cash to clean-up and restore its facilities, including $201 million in capital expenditures. During the three months ended September 30, 2006, and 2005, the company incurred clean-up and restoration costs of $11 million and $15 million and capital expenditures of $26 million and $0, respectively. During the nine months ended September 30, 2006, and 2005, the company incurred clean-up and restoration costs of $46 million and $15 million and capital expenditures of $121 million and $0, respectively. As of September 30, 2006, the company has written off $62 million in assets that were completely destroyed by the storm, of which $49 million was written off during the three months ended September 30, 2005. Also during the third quarter of 2005, the company recorded a pre-tax adjustment to reduce the earned margin on its contracts in process by $150 million ($98 million after-tax) to recognize the effects of hurricane-related contract cost growth.

 

The company has submitted estimated expenditures for recovery to its insurance carriers that are substantially in excess of the insurance proceeds received to date, and is awaiting resolution of its submissions. The company is continuing to assess its damage estimates as the process of repairing its operations is performed. The company estimates this process will continue through 2008.

 

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.

 

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 11. 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.

 

 

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

 

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a contractor may lead to suspension or debarment from future U.S. Government contracts or the loss of export privileges for a company or an operating division or subdivision. Suspension or debarment could have a material adverse effect on the company because of its reliance on government contracts.

 

As previously disclosed, in October 2005, the U.S. Department of Justice and a classified U.S. Government customer apprised the company of potential substantial claims relating to certain microelectronic parts produced by the Space and Electronics Sector of former TRW Inc., now a component of the company. The relationship, if any, between the potential claims and a civil False Claims Act case that remains under seal in the U.S. District Court for the Central District of California remains unclear to the company. In the third quarter of 2006, the parties commenced settlement discussions. While the company continues to believe that it did not breach the contracts in question and that it acted appropriately in this matter, the company proposed to settle the claims and any associated matters and recognized a pre-tax charge of $112.5 million in the three months ended September 30, 2006, to cover the cost of the settlement proposal and associated investigative costs incurred through September 30, 2006. The charge has been recorded within general and administrative expenses in the accompanying Consolidated Condensed Statements of Income. The company extended the offer in an effort to avoid litigation and in recognition of the value of the relationship with this customer. The U.S. Government has advised the company that if settlement is not reached it will pursue its claims through litigation. Because of the highly technical nature of the issues involved and their classified status and because of the significant disagreement between the company and the U.S. Government as to the U.S. Government’s theories of liability and damages (including a material difference between the U.S. Government’s damage theories and the company’s offer), final resolution of this matter could take a considerable amount of time particularly if litigation should ensue. If the U.S. Government were to pursue litigation and were to be ultimately successful on its theories of liability and damages, which could be trebled under the Federal False Claims Act, the effect upon the company’s consolidated financial position, results of operations, and cash flows would materially exceed the amount provided at September 30, 2006. Based upon the information available to the company to date, the company believes that it has substantive defenses but can give no assurance that its views will prevail. Accordingly, the ultimate disposition of this matter cannot presently be determined.

 

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

 

Litigation – Various claims and legal proceedings arise in the ordinary course of business and are pending against the company and its properties. Based upon the information available, and apart from the specific matters discussed below, 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 consolidated financial position, results of operations, or cash flows.

 

The company is a defendant in litigation brought by Cogent Systems, Inc. (Cogent) in Los Angeles Superior Court in California on April 20, 2005, for unspecified damages for alleged unauthorized use of Cogent technology relating to fingerprint recognition. During discovery in the second quarter of 2006, Cogent asserted entitlement to in excess of $50 million for lost profits, in excess of $100 million for loss of goodwill and business opportunities, in excess of $6 million in royalties, doubling of actual damages and other amounts, including, without limitation, attorneys’ fees. The September 12, 2006, scheduled trial date was continued to an unspecified date, but is expected to be set sometime in 2007. The company does not believe, but can give no assurance, that the outcome of this matter would have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

On September 28, 2006, various individual plaintiffs filed a class action lawsuit in the United States District Court, Central District of California, against the company, certain of its administrative and Board committees, all members of the company’s Board of Directors, and certain company officers and employees (Waldbuesser, et al. v. Northrop Grumman Corporation, et al.). The lawsuit alleges two alternative counts of fiduciary duty breaches under the Employee Retirement Income Security Act of 1974 with respect to alleged excessive, hidden and/or otherwise improper fee and expense charges to the Northrop Grumman Savings Plan and the Northrop

 

NORTHROP GRUMMAN CORPORATION

Grumman Financial Security and Savings Plan (each of which are 401(k) plans). Among other things, the lawsuit seeks unspecified damages, removal of individuals acting as fiduciaries to such plans, payment of attorney fees and costs, and an accounting. The company does not believe, but can give no assurance, that the outcome of this matter would have a material adverse effect on its consolidated 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 June 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.

 

 

Contract Performance Contingencies – Contract profit margins may include estimates of costs not contractually agreed to between the customer and the company for matters such as contract changes, negotiated settlements, claims and requests for equitable adjustment for previously unanticipated contract costs. These estimates are based upon management’s best assessment of the underlying causal events and circumstances, and are included in determining contract profit margins to the extent of expected recovery based on contractual entitlements and the probability of successful negotiation with the customer. As of September 30, 2006, the amounts recorded are not material individually or in the aggregate.

 

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 September 30, 2006, the range of reasonably possible future costs for environmental remediation sites is $235 million to $332 million, of which $268 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 whereby Ships leases facility improvements and equipment from Mississippi and from a non-profit economic development corporation in Louisiana in exchange for certain commitments by Ships to these states.

 

As of September 30, 2006, Ships is obligated under the Mississippi agreement to create 666 new full-time jobs in Mississippi and match state funding expenditures of $112 million by December 2009.

 

During the three months ended September 30, 2006, the original Louisiana agreement was amended to allow, upon assembly and installation of certain equipment, the employment requirements to be calculated using a four-year average. As of September 30, 2006, Ships is obligated to maintain a minimum average of 5,200 full-time employees at the end of any four-year period occurring between January 1, 2003, and December 31, 2010.

 

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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 September 30, 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 utilizes standby letters of credit and guarantees issued by commercial banks and surety bonds issued by insurance companies principally to guarantee the performance on certain contracts and to support the company’s self-insured workers’ compensation plans. At September 30, 2006, there were $436 million of unused stand-by letters of credit, $98 million of bank guarantees, and $605 million of surety bonds outstanding.

 

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

 

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

 

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

 

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

 

NORTHROP GRUMMAN CORPORATION

 

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

 

 

Employer Contributions – The company expects to contribute approximately $1.1 billion to its pension plans, including a voluntary pre-funding of $800 million, and approximately $185 million to its medical and life benefits plans in 2006. As of September 30, 2006, contributions of $316 million and $127 million have been made to the company’s pension plans and its medical and life benefit plans, respectively.

 

Pension Reform – On August 17, 2006, the Pension Protection Act of 2006 (Act) was signed into law by President Bush. Key provisions of the Act include a requirement to fully fund pension plans within seven years and an increase in the annual deduction limit applicable to pension plan participants. Certain of the company’s pension plans are under-funded. The company is currently evaluating the impact of the Act on its consolidated financial position, results of operations and cash flows.

 

 

At September 30, 2006, the company had stock-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 the employee 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

 

NORTHROP GRUMMAN CORPORATION

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 nine months ended September 30, 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 and nine month periods ended September 30, 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 nine months ended September 30, 2006, and 2005, was $156 million and $109 million, respectively, of which $9 million and $3 million related to Stock Options and $147 million and $106 million related to Stock Awards, respectively. Tax benefits recognized in the consolidated condensed statements of income for stock-based compensation during the nine months ended September 30, 2006, and 2005, were $54 million and $38 million, respectively. In addition, the company realized excess tax benefits of $47 million from the exercise of Stock Options and $5 million from the vesting of Stock Awards in the nine months ended September 30, 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, 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 nine months ended September 30, 2006, and 2005, were as follows:

 

 

The weighted average grant date fair value of Stock Options granted during the nine months ended September 30, 2006, and 2005, was $18 and $16 per share, respectively.

 

NORTHROP GRUMMAN CORPORATION

Stock Option activity for the nine months ended September 30, 2006, was as follows:

 

 

The total intrinsic value of options exercised during the nine months ended September 30, 2006, and 2005, was $134 million and $29 million, respectively. Intrinsic value is measured using the fair market value at the date of exercise (for options exercised) or at September 30, 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. For purposes of measuring compensation expense, the amount of shares ultimately expected to vest is estimated at each reporting date based on management’s expectations regarding the relevant performance criteria. In the table below, the share adjustment resulting from the final performance measure is considered granted in the period that the related grant is vested. There were 1.9 million Stock Awards that vested and were issued in the nine months ended September 30, 2005, with a total fair value of $104 million. There were 2.4 million Stock Awards granted in the nine months ended September 30, 2005, with a weighted average grant date fair value of $54 per share.

 

Stock Award activity for the nine months ended September 30, 2006, was as follows:

 

 

Unrecognized Compensation Expense – At September 30, 2006, there was $294 million of unrecognized compensation expense related to unvested awards granted under the company’s stock-based compensation plans, of which $18 million relates to Stock Options and $276 million relates to Stock Awards. These amounts 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 and nine months ended September 30, 2005, been determined based on the fair value at the grant dates for Stock Awards and Stock Options, consistent

 

NORTHROP GRUMMAN CORPORATION

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:

 

 

NORTHROP GRUMMAN CORPORATION

 

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 September 30, 2006, and the related consolidated condensed statements of income and comprehensive income for the three-month and nine-month periods ended September 30, 2006 and 2005, and the related consolidated condensed statements of cash flows and changes in shareholders’ equity for the nine-month periods ended September 30, 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.

 

 

Los Angeles, California

October 23, 2006

 

NORTHROP GRUMMAN CORPORATION

 

 

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 (U.S.) and abroad. Northrop Grumman conducts most of its business with the 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 Newport News and Ship Systems.

 

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.

 

 

The company’s financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). The preparation of the financial statements requires management to make estimates and 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 and nine months ended September 30, 2006.

 

 

Selected financial highlights are presented in the table below.