UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-Q

 

 

 

 

Commission File Number
1-16411

 

 

NORTHROP GRUMMAN CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

 

1840 Century Park East, Los Angeles, California 90067
www.northropgrumman.com

(Address of principal executive offices and internet site)

 

 

(310) 553-6262

(Registrant’s telephone number, including area code)

 

 

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

 

 

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

 

 

 

 

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

 

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

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

 

As of July 20, 2007, 345,917,678 shares of common stock were outstanding.

 

 

NORTHROP GRUMMAN CORPORATION

 

Table of Contents

 

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

 

 

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 intercompany accounts, transactions, and profits are eliminated in consolidation.

 

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

 

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

 

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

 

Financial Statement Reclassifications – Certain amounts in the prior period financial statements and related notes have been reclassified to conform to the 2007 presentation, due to the business operations realignments described in Note 6.

 

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

 

Other new pronouncements issued but not effective until after June 30, 2007, 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 February 2007, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 159 – The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115. SFAS No. 159 permits entities to choose to measure eligible items at fair value at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. SFAS No. 159 is effective for the company beginning January 1, 2008. 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 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

 

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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.

 

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

 

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

 

Essex – On January 25, 2007, the company acquired Essex Corporation (Essex) for approximately $600 million, including the assumption of debt totaling $23 million and estimated transaction costs of $15 million. Essex provides signal processing services and products, and advanced optoelectronic imaging for U.S. government intelligence and defense customers. The operating results of Essex are reported in the Mission Systems segment since February 1, 2007. The assets, liabilities, and results of operations of Essex were not material to the company’s consolidated financial position or results of operations and thus pro-forma information is not presented. The consolidated financial statements reflect preliminary estimates of the fair value of the assets acquired and liabilities assumed and the related allocation of the purchase price for Essex. During the first quarter of 2007, approximately $66 million of the purchase price was allocated to purchased intangibles (Note 8), and the company is reviewing its preliminary fair value adjustments associated with purchased intangibles. The ultimate allocation of the purchase price may differ from the amounts included in these financial statements. Management does not expect these adjustments, if any, to have a material effect on the company’s financial position or results of operations, and such adjustments will be finalized by the first quarter of 2008.

 

2007 – During the second quarter, management announced its strategic decision to exit the business of manufacturing printed circuit boards for third parties reported within the Electronics segment as Interconnect Technologies (ITD). Sales for this business for the six months ended June 30, 2007, and 2006, were $8 million and $23 million, respectively. The shut-down of the ITD business is expected to be completed by the end of the third quarter of 2007 and is not expected to have a material effect on the company’s consolidated financial position, results of operations, or cash flows.

 

2006 – The company sold the assembly business unit of ITD during the first quarter of 2006 and Winchester Electronics (Winchester) during the second quarter of 2006 for net cash proceeds of $26 million and $17 million, respectively, and recognized after-tax gains of $5 million and $2 million, respectively, in discontinued operations. The results of operations of the assembly business unit of ITD and Winchester, reported in the Electronics segment, were not material to any of the periods presented and have therefore not been reclassified as discontinued operations.

 

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

 

Effective January 1, 2007, the company realigned businesses among its operating segments that possess similar customers, expertise, and capabilities. The realignment more fully leverages existing capabilities and enhances

 

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development and delivery of highly integrated services. The realignment primarily involved the transfer of the Radio Systems business from the Space Technology segment to the Mission Systems segment and the transfer of the UK Airborne Warning and Control System program from the Information Technology segment to the Technical Services segment. On July 1, 2006, certain logistics, services and technical support programs were transferred from Electronics, Integrated Systems, Mission Systems, and Space Technology to Technical Services. The sales and segment operating margin in the following tables have been revised, where applicable, to reflect these realignments for all periods presented.

 

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

 

 

NORTHROP GRUMMAN CORPORATION

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

 

 

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) and the Federal Acquisition Regulation, and therefore not allocated to the segments.

 

Net Pension Adjustment – Net pension adjustment reflects the difference between pension expense determined in accordance with GAAP and pension expense allocated to the operating segments determined in accordance with CAS. For the three months ended June 30, 2007, and 2006, pension expense determined in accordance with GAAP was $87 million and $113 million, respectively, and pension expense determined in accordance with CAS amounted to $115 million and $101 million, respectively. For the six months ended June 30, 2007, and 2006, pension expense determined in accordance with GAAP was $174 million and $225 million, respectively, and pension expense determined in accordance with CAS was $235 million and $203 million, respectively.

 

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

 

Diluted Earnings Per Share – Diluted earnings per share includes the dilutive effect of stock options and other stock awards granted to employees under stock-based compensation plans and, for 2007, the company’s mandatorily redeemable convertible series B preferred stock. The dividends and the 6.4 million shares related to the preferred stock were not included in the diluted per share calculations for the three and six months ended June 30, 2006, because their effect was not dilutive to earnings per share. The weighted average diluted shares

 

NORTHROP GRUMMAN CORPORATION

outstanding for the three and six months ended June 30, 2007, exclude stock options to purchase approximately 5,000 and 19,000 shares, respectively, since such options have an exercise price in excess of the average market price of the company’s common stock during the period. The weighted average diluted shares outstanding for the three and six months ended June 30, 2006, exclude stock options to purchase approximately zero and 20,000 shares, respectively.

 

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

 

 

Share Repurchases – On December 14, 2006, the company’s board of directors authorized a share repurchase program of up to $1 billion of its outstanding common stock. This authorization was in addition to $176 million remaining on the company’s previous share repurchase authorization which commenced in November 2005. As of June 30, 2007, the company has $584 million authorized for share repurchases remaining.

 

Since November 2005 the company has entered into three separate accelerated share repurchase agreements with Credit Suisse, New York Branch (Credit Suisse) to repurchase shares of common stock. Credit Suisse in each case 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. The cost of the company’s share repurchases were subject to adjustment based on the actual cost of the shares subsequently purchased by Credit Suisse. If additional cost was owed by the company upon settlement, the price adjustment could have been settled, at the company’s option, in cash or in shares of common stock.

 

The table below summarizes the accelerated share repurchase transactions:

 

 

As of June 7, 2007, Credit Suisse completed its purchases under the latest agreement, and paid the company $8 million for the final purchase price adjustment under the terms of the agreement.

 

NORTHROP GRUMMAN CORPORATION

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.

 

Goodwill

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

 

 

Fair Value Adjustments to Net Assets Acquired - The fair value adjustments were primarily due to the reversal of uncertain tax liabilities in conjunction with a favorable settlement of Internal Revenue Service (IRS) audits of pre-acquisition period tax returns (See Note 14).

 

Purchased Intangible Assets

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

 

 

During the quarter ended March 31, 2007, approximately $66 million of the Essex purchase price was allocated to purchased intangible assets with a weighted average life of 6 years, and are included as part of contract and program intangibles.

 

The company’s purchased intangible assets are subject to amortization and are being amortized on a straight-line basis over an aggregate weighted average period of 21 years. Aggregate amortization expense for the three and six months ended June 30, 2007, was $33 and $66 million, respectively.

 

NORTHROP GRUMMAN CORPORATION

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

 

 

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

 

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

 

On May 17, 2007, the U.S. Coast Guard issued a revocation of acceptance under the Deepwater Program for eight converted 123-foot patrol boats (the vessels) based on alleged “hull buckling and shaft alignment problems.” By letter dated June 5, 2007, the Coast Guard stated that the revocation of acceptance also was based on alleged “nonconforming topside equipment” on the vessels. The contract value associated with the eight converted vessels is approximately $85 million. The Coast Guard has not specified the amount of damages sought in connection with the eight vessels. Based upon the information available to the company to date, the company believes that it has substantive defenses but can give no assurance that its views will prevail. However, the

 

NORTHROP GRUMMAN CORPORATION

company believes, but can give no assurance, that the outcome of this matter would not have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

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

 

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

 

As previously disclosed, the company is a defendant in litigation brought by Cogent Systems, Inc. (Cogent) in Los Angeles Superior Court in California on April 20, 2005, for unspecified damages for alleged unauthorized use of Cogent technology relating to fingerprint recognition. Cogent has asserted entitlement to damages totaling in excess of $160 million, loss of goodwill and enterprise value in an amount not yet specified by the plaintiff, and other amounts, including, without limitation, exemplary damages and attorneys’ fees and interest. In early May 2007, the court granted Cogent’s motion for summary judgment on its declaratory relief cause of action and ordered that a prior license agreement between Cogent and the company related to the British Police Force’s National Automatic Fingerprint Identification System program did not give the company the right to sell, market, license, use, disclose, disseminate, or otherwise transfer Cogent’s technology, software, source code, trade secrets, or confidential and proprietary information and any information or products derived therefrom, including any benchmark system or other system for use in connection with a follow-on system for the British Police Force called IDENT1; and ordered the company to immediately return to Cogent all of Cogent’s proprietary technology, including Cogent’s software and source code. In recent discovery responses, by declaration of counsel, Cogent has stated that it no longer seeks damages based on its loss of enterprise value or goodwill. The trial, previously set for May 22, 2007, has been continued until September 4, 2007. The company believes, but can give no assurance, that the outcome of this matter would not have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

As previously reported, on March 27, 2007, the U.S. District Court, Central District of California, consolidated two separately filed ERISA class actions (Grabek v. Northrop Grumman Corporation, et al., previously styled Waldbuesser v. Northrop Grumman Corporation, et al., and Heidecker v. Northrop Grumman Corporation, et al.) into the In Re Northrop Grumman Corporation ERISA Litigation for discovery and other purposes, as each allege similar issues of law and fact. Also as previously reported, plaintiffs in Grabek allege breaches of fiduciary duty by the company, certain of its administrative and Board committees, all members of the company’s Board of Directors, and certain company officers and employees with respect to alleged excessive, hidden and/or otherwise improper fee and expense charges to the Northrop Grumman Savings Plan and the Northrop Grumman Financial Security and Savings Plan (both of which are 401(k) plans). Heidecker asserts similar claims, but had dismissed the company’s Board of Directors. On May 21, 2007, the Court granted a motion to dismiss with prejudice the company and the Board of Directors from the Grabek litigation. On May 25, 2007, the Court entered an order dismissing the company with prejudice from the Heidecker lawsuit, the Directors having been previously dismissed as noted above. Each lawsuit seeks unspecified damages, removal of individuals acting as fiduciaries to such plans, payment of attorney fees and costs, and an accounting. The company believes, but can give no assurance, that the outcome of these matters would not have a material adverse effect on its consolidated financial position, results of operations, or cash flows.

 

Insurance Recovery – Property damage from Hurricane Katrina is covered by the company’s comprehensive property insurance program. The insurance provider for coverage of property damage losses over $500 million, FM Global Insurance (FM Global), has advised management of a disagreement regarding coverage for certain losses above $500 million. As a result, the company has taken legal action against the insurance provider as the

 

NORTHROP GRUMMAN CORPORATION

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 assessment and claim process, no assurances can be made as to the ultimate outcome of this matter (See Note 11).

 

Provisions for Legal & Investigative Matters – Litigation accruals are recorded as charges to earnings when management, after taking into consideration the facts and circumstances of each matter, including any settlement offers, has determined that it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. The ultimate resolution of any exposure to the company may vary from earlier estimates as further facts and circumstances become known. During the three months ended June 30, 2007, the company recorded a $50 million provision for various legal and investigative matters.

 

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 June 30, 2007, the amounts recorded are not material individually or in the aggregate.

 

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

 

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 be required to incur such costs in the future to address environmental impacts at currently or formerly owned or leased operating facilities, or at sites where it has been named a Potentially Responsible Party (PRP) by the Environmental Protection Agency, or similarly designated by other environmental agencies. To assess the potential impact on the company’s consolidated financial statements, management estimates the total reasonably possible remediation costs that could be incurred by the company, taking into account currently available facts on each site as well as the current state of technology and prior experience in remediating contaminated sites. These estimates are reviewed periodically and adjusted to reflect changes in facts and technical and legal circumstances. Management estimates that as of June 30, 2007, the range of reasonably possible future costs for environmental remediation sites was $220 million to $314 million, of which $241 million is accrued in other current liabilities. 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.

 

Income Tax Matters – The company has exposure related to income tax matters arising from indemnifications of businesses divested. The company periodically assesses these exposures for all tax years that are open under the applicable statute of limitations and records a liability, including related interest charges, where it has determined that a liability has been incurred and the amount of the loss can be reasonably estimated. Liabilities under

 

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indemnification agreements for businesses divested are recorded at fair value at the inception of the indemnification and presented within income taxes payable. These primarily relate to indemnifications of foreign taxes as a result of the divestiture of TRW Auto in 2003 and total approximately $146 million and $145 million at June 30, 2007, and December 31, 2006, respectively. Management does not believe that the resolution of any of these income tax exposures will have a material adverse effect on the company’s consolidated financial position or results of operations.

 

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

 

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

 

Financial Arrangements – In the ordinary course of business, the company utilizes standby letters of credit and guarantees issued by commercial banks and surety bonds issued by insurance companies principally to guarantee the performance on certain contracts and to support the company’s self-insured workers’ compensation plans. At June 30, 2007, there were $389 million of unused stand-by letters of credit, $148 million of bank guarantees, and $548 million of surety bonds outstanding.

 

In December 2006, Ships entered into a loan agreement with the Mississippi Business Finance Corporation (MBFC) under which Ships received access to $200 million from the issuance of Gulf Opportunity Zone Industrial Development Revenue Bonds by the MBFC. The loan accrues interest payable semi-annually at a fixed rate of 4.55 percent per annum. The company’s obligation related to these bonds is recorded in “Long-term debt” in the consolidated condensed statements of financial position. The bonds are subject to redemption at the company’s discretion on or after December 1, 2016, and mature on December 1, 2028. The bond issuance proceeds must be used to finance the construction, reconstruction, and renovation of the company’s interest in certain ship manufacturing and repair facilities, or portions thereof, located in the state of Mississippi. As of June 30, 2007, approximately $105 million was used by Ships and the remaining $95 million was recorded in other assets as restricted cash in the consolidated condensed statement of financial position. Repayment of the bonds is guaranteed by the company.

 

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

 

In May 2006, Goodrich Corporation (Goodrich) notified the company of its claims under indemnities assumed by the company in its December 2002 acquisition of TRW that related to the sale by TRW of its Aeronautical Systems business in October 2002. Goodrich seeks relief from increased costs and other damages of approximately $118 million. The parties are engaged in discussions to enable the company to evaluate 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, Goodrich will have the right to commence litigation and may seek significant additional damages relating to allegations of other incurred costs and lost profits. The ultimate disposition of any litigation could take an extended period of time due to the nature of the claims. 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.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

NORTHROP GRUMMAN CORPORATION

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

 

Insurance Claim – The company’s aggregate claim for insurance recovery as a result of Hurricane Katrina is estimated to be $1,216 million, consisting of clean-up and restoration costs of $278 million, property damages and other capital expenditures of $572 million and lost profits of $366 million. Certain amounts within the overall claim are still in the process of being finalized and the overall value of the claim may change from these amounts.

 

In June 2007, the company reached a final agreement with all but one of the insurers in its first layer of coverage under which the insurers agreed to pay their policy limits (less the policy deductible and certain other minor costs). As a result of the agreement regarding the claims from the first layer of coverage, the company received a total insurance recovery for damages to the shipyards of $466 million reflecting policy limits less certain minor costs. The company is continuing to seek recovery of its claim from the remaining insurer in the first layer that did not participate in the agreement. As a result of the agreement, the company received final cash payments totaling $113 million in the quarter ended June 30, 2007, of which $62 million has been attributed to the recovery of lost profits due to the storm and recognized in the consolidated condensed statement of income for this period as an adjustment to operating margin (cost of product sales) in the Ships segment. Through June 30, 2007, cumulative proceeds from the agreement have also been used to fund $126 million in capital expenditures for assets fully or partially damaged by the storm and $278 million in clean-up and restoration costs. Insurance recoveries received to date have enabled the company to recover the entire net book value of $98 million of assets totally or partially destroyed by the storm. To the extent that the company is unsuccessful in receiving the full value of its remaining claim relating to capital assets, the company will fund the capital expenditures. Through June 30, 2007, the company has incurred capital expenditures totaling $239 million related to assets damaged by the hurricane, of which approximately two-thirds represents the replacement cost of assets destroyed and the remainder represents the capitalized value of asset improvements that extended the useful life of assets damaged by the storm.

 

The company expects that its residual claim will be resolved separately with the remaining insurers in each of its two layers of coverage, and the company has pursued the resolution of its claim with that understanding. The insurer for the second layer of coverage has denied coverage for substantial portions of the company’s claim and the parties are presently in litigation to resolve this matter (see Note 9).

 

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

 

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 $155 million to its pension plans and approximately $217 million to its medical and life benefit plans in 2007. As of June 30, 2007, contributions of $65 million and $69 million have been made to the company’s pension plans and its medical and life benefit plans, respectively.

 

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

 

Compensation Expense – Total pre-tax stock-based compensation for the six months ended June 30, 2007, and 2006, was $78 million and $107 million, respectively, of which $7 million and $6 million, related to Stock Options and $71 million and $101 million related to Stock Awards, respectively. Tax benefits recognized in the consolidated condensed statements of income for stock-based compensation during the six months ended June 30, 2007, and 2006, were $30 million and $38 million, respectively. In addition, the company realized excess tax benefits of $39 million and $42 million from the exercise of Stock Options and $22 million and $5 million from the vesting of Stock Awards in the six months ended June 30, 2007, and 2006, respectively.

 

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.

 

NORTHROP GRUMMAN CORPORATION

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

 

 

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

 

Stock Option activity for the six months ended June 30, 2007, was as follows:

 

 

The total intrinsic value of options exercised during the six months ended June 30, 2007, and 2006, was $100 million and $120 million, respectively. Intrinsic value is measured using the fair market value at the date of exercise (for options exercised) or at June 30, 2007 (for outstanding options), less the applicable exercise price.

 

Stock Awards – Compensation expense for Stock Awards is measured at the grant date based on fair value and recognized over the vesting period. The fair value of Stock Awards is determined based on the closing market price of the company’s common stock on the grant date. For purposes of measuring compensation expense, the amount of shares ultimately expected to vest is estimated at each reporting date based on management’s expectations regarding the relevant performance criteria. In the table below, the share adjustment resulting from the final performance measure is considered granted in the period that the related grant is vested. During the six months ended June 30, 2007, 2.6 million shares of common stock were issued to employees in settlement of prior year stock awards that were fully vested, with a total value upon issuance of $198 million and a grant date fair value of $124 million. During the six months ended June 30, 2006, 2.4 million shares of common stock were issued to employees in settlement of prior year stock awards that were fully vested, with a total value upon issuance of $155 million and a grant date fair value of $132 million. There were 3.4 million Stock Awards granted in the six months ended June 30, 2006, with a weighted average grant date fair value of $65 per share.

 

NORTHROP GRUMMAN CORPORATION

Stock Award activity for the six months ended June 30, 2007, was as follows:

 

 

Unrecognized Compensation Expense – At June 30, 2007, there was $288 million of unrecognized compensation expense related to unvested awards granted under the company’s stock-based compensation plans, of which $21 million relates to Stock Options and $267 million relates to Stock Awards. These amounts are expected to be charged to expense over a weighted average period of 1.7 years.

 

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

 

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

 

The company files income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. The IRS is currently examining the company’s U.S. income tax returns for 1999 – 2003, including pre-acquisition activities of acquired companies, and in the first quarter of 2007 commenced an examination of the company’s U.S. income tax returns for 2004 – 2005. In addition, open tax years related to state and foreign jurisdictions remain subject to examination but are not considered material.

 

During the second quarter of 2007, the company entered into a partial settlement agreement with the IRS for the tax years 2001 – 2003. The company reduced its liability for uncertain tax positions related to the partial settlement agreement and other matters by $52 million during the second quarter of 2007, of which $36 million was recorded as a reduction of goodwill.

 

NORTHROP GRUMMAN CORPORATION

 

The components of accumulated other comprehensive loss were as follows:

 

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 (the “Corporation”) as of June 30, 2007, and the related consolidated condensed statements of income and comprehensive income for the three-month and six-month periods ended June 30, 2007 and 2006, and the related consolidated condensed statements of cash flows and changes in shareholders’ equity for the six-month periods ended June 30, 2007 and 2006. 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, 2006, 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 20, 2007, 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, 2006 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

July 23, 2007

 

NORTHROP GRUMMAN CORPORATION

 

The following discussion should be read along with the unaudited consolidated condensed financial statements included in this Form 10-Q, as well as the company’s 2006 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 (the company) 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, the company participates in many high-priority defense and commercial technology programs in the United States (U.S.) and abroad. The company 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.

 

Overall Operating Performance – Operating performance for the three and six months ended June 30, 2007, compared to the same period in 2006 improved in almost every consolidated financial measure. Sales, operating margin, net income, net cash from operations, and funded backlog all increased over the same period in 2006. See discussion of consolidated results starting on page I-25 and discussion of results by reportable segment starting on page I-28.

 

Business Outlook and Operational Trends – The company’s shipyard operations in the Gulf Coast continue to be impacted from the effects of property damage and workforce shortages resulting from hurricanes in 2005 and a recent workforce stoppage due to union negotiations. While operational issues continue to exist, management believes it has an executable recovery plan in place.

 

Other than the matter discussed above, there have been no material changes to the company’s products and services, industry outlook, or business trends from those disclosed in the company’s 2006 Annual Report on Form 10-K.

 

Notable Events – Notable events or activity during the six months ended June 30, 2007, affecting the company’s financial results included the following:

 

Three Months Ended March 31, 2007

 

Three Months Ended June 30, 2007