UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2006

 

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 (310) 553-6262

www.northropgrumman.com

(Address and telephone number of principal executive offices and internet site)

 

Securities registered pursuant to section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined 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 Act).

 

As of June 30, 2006, the aggregate market value of the common stock (based upon the closing price of the stock on the New York Stock Exchange) of the registrant held by non-affiliates was approximately $22,063 million.

 

As of February 16, 2007, 350,262,436 shares of common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of Northrop Grumman Corporation’s Proxy Statement for the 2007 Annual Meeting of Stockholders are incorporated by reference in Part III of this Form 10-K.

 

 

NORTHROP GRUMMAN CORPORATION

 

TABLE OF CONTENTS

 

NORTHROP GRUMMAN CORPORATION

 

HISTORY AND ORGANIZATION

 

History

Northrop Grumman Corporation (“Northrop Grumman” or the “company”) is an integrated enterprise consisting of some 25 formerly separate businesses that cover the entire defense spectrum, from undersea to outer space and into cyberspace. The companies that have become part of today’s Northrop Grumman achieved historic accomplishments, from transporting Charles Lindbergh across the Atlantic to carrying astronauts to the moon’s surface and back.

 

From 1994 through 2002, the company entered a period of significant expansion through acquisitions of other businesses, most notably:

 

 

The acquisition of these and other businesses have shaped the company into its present position as a premier provider of technologically advanced, innovative products, services and solutions in information and services, aerospace, electronics and shipbuilding. As prime contractor, principal subcontractor, partner, or preferred supplier, Northrop Grumman participates in many high-priority defense and non-defense technology programs in the U.S. and abroad. The company conducts most of its business with the U.S. Government, principally the Department of Defense (DoD), and it also conducts business with foreign governments as well as other domestic and international customers.

 

Organization

The company is aligned into seven reportable segments categorized into four primary businesses. The Mission Systems, Information Technology, and Technical Services segments are presented as Information & Services. The

 

NORTHROP GRUMMAN CORPORATION

Technical Services segment was created on January 1, 2006, from programs transferred from other segments. The Integrated Systems and Space Technology segments are presented as Aerospace. The Electronics and Ships segments are each presented as separate businesses. Newport News and Ship Systems are aggregated and reported as the Ships business in accordance with the provisions of Statement of Financial Accounting Standards No. 131 – Disclosures about Segments of an Enterprise and Related Information.

 

The company, from time to time, acquires or disposes of businesses, and realigns contracts, programs or business areas among its operating segments that possess similar customers, expertise, and capabilities. These realignments are designed to more fully leverage existing capabilities and enhance development and delivery of products and services. The operating results for all periods presented have been revised to reflect these changes made through December 31, 2006.

 

INFORMATION & SERVICES

 

Mission Systems

The Mission Systems segment, headquartered in Reston, Virginia, is a leading global systems integrator of complex, mission-enabling systems. The segment consists of three areas of business: Command, Control & Intelligence (C2I) Systems; Missile Systems; and Technical & Management Services.

 

C2I Systems – C2I Systems provides a variety of command, control, communications, computers, and intelligence support to the various branches of the U.S. DoD and the Intelligence Community. Offerings include signals intelligence and exploitation systems, system engineering and integration, data collection and operations and maintenance, modeling and product generation, system simulation, integration and test, spacecraft command and control (C2) systems, payload control and terminal software, airborne reconnaissance, U.S. Army tactical global combat service support, U.S. Army management information systems, joint service nuclear, biological and chemical reconnaissance systems, tactical operation centers, interoperable C2 solutions, mission planning applications, tactical data link products, global command and control systems, interoperability engineering, intelligence gathering, and naval systems engineering support and integration.

 

Missile Systems – Missile Systems supports the U.S. integrated Missile Defense system and the Intercontinental Ballistic Missile (ICBM) Program. The integrated Missile Defense system market includes shooters, sensors, battle management, command, control, communications (BMC3), modeling and simulation, and test and evaluation. The business area provides BMC3 systems, war games, modeling and simulation, system test and integration, and missile system engineering to the Missile Defense Agency, Boeing, and Lockheed Martin. As prime contractor for the Kinetic Energy Interceptor (KEI) program, the company is leading development and test activities focused on the boost, ascent and midcourse phases of the Missile Defense Agency’s global layered missile defense system. As prime contractor for the ICBM Program Office, the company offers ICBM domain knowledge, program management, systems engineering and integration, and sustainment and modernization services.

 

Technical & Management Services – Technical & Management Services primarily supports the DoD. Products and services offered include information systems, life cycle design, development, integration, and operations, electromagnetic and infrared analysis, decision support with modeling tools, systems effectiveness evaluation, sensor systems integration, engineering prototypes and integration, joint training mission rehearsals, and force modernization and integration.

 

Information Technology

The Information Technology segment, headquartered in McLean, Virginia, consists of four areas of business: Intelligence; Defense; Civilian Agencies; and Commercial, State & Local.

 

Intelligence – Intelligence provides information technology (IT) systems, services and solutions primarily to the U.S. Intelligence Community, which includes customers in national agencies, defense, homeland security, and other agencies at the federal, state and local level. This business area also collaborates with other Information Technology business areas by providing specialized technology solutions in areas such as information security,

 

NORTHROP GRUMMAN CORPORATION

secure wireless communications, secure cross agency information-sharing and geospatial information systems. Services and solutions span the entire mission life cycle from requirements and technology development through processing and data analysis to information delivery.

 

Defense – Defense provides IT systems, services and solutions to all elements of the DoD including the Air Force, Navy, Army, Marines, the Office of the Secretary of Defense, and the Unified Combatant Commands. Offerings include business applications and systems integration related to human capital and business management, logistics, transportation, supply chain, and combat systems support. Other offerings consist of information technology and network infrastructures, including modernization, architecture, design and capacity modeling. Defense also provides solutions and services for defense technology laboratories and research and development centers, system program offices, operational commands, education and training commands, test centers, and other defense agencies.

 

Civilian Agencies – Civilian Agencies provides IT systems, services and solutions primarily for federal civilian agencies, as well as government and commercial healthcare customers. Civilian Agencies customers include the departments of Homeland Security, Treasury, Justice, Transportation, State, Interior, and the U.S. Postal Service. Homeland Security offerings include secure networking, criminal justice systems, and identity management. Healthcare customers include the Department of Health and Human Services, DoD Health Affairs, the Centers for Disease Control and Prevention, the Food and Drug Administration, the Department of Veterans Affairs, and a number of pharmaceutical manufacturers. Healthcare offerings include enterprise architecture, systems integration, infrastructure management, document management, human capital management, case management, specialized health IT solutions in electronic medical records, public health, bio-surveillance, benefits, and clinical research.

 

Commercial, State & Local – Commercial, State & Local provides IT systems, services and solutions primarily for state and local agencies and commercial customers. The commercial business centers on managed IT services both as a prime contractor and partner in addition to specialized solutions that address specific business needs. The state and local focus includes public safety, secure wireless solutions, human services, and managed IT services. This business area provides IT outsourcing services on a “service level agreement” basis, where contractual terms are based on infrastructure volume and service levels. Services include management of data centers, networks, desktops, storage, security, help desk, and applications. Specialized state and local offerings include systems for police/fire/medical emergency dispatch, public safety command centers, biometric identification, and human services.

 

Technical Services

The Technical Services segment, headquartered in Herndon, Virginia, provides infrastructure management and maintenance, training and preparedness, and logistics and life cycle management in a wide array of operating environments. The segment consists of three areas of business: Systems Support, Training and Simulation, and Life Cycle Optimization and Engineering.

 

Systems Support – Systems Support provides infrastructure and base operations management, including base support and civil engineering work, military range work, support functions which include construction, combat vehicle maintenance, protective and emergency services, launch services, and range-sensor-instrumentation operations. Primary customers include the Department of Energy, the DoD, the National Aeronautics and Space Administration (NASA), the Department of Homeland Security, and the U.S. Intelligence Community, in both domestic and international locations.

 

Training and Simulation – Training and Simulation provides realistic and comprehensive training to senior military leaders and peacekeeping forces, designs and develops future conflict training scenarios, and provides U.S. warfighters and international allies with live, virtual, and constructive training programs. This business area also offers diverse training applications ranging from battle command to professional military education.

 

NORTHROP GRUMMAN CORPORATION

 

Life Cycle Optimization and Engineering – Life Cycle Optimization and Engineering provides complete life cycle product and weapons system sustainment. This business area is focused on providing direct support to warfighters with supply chain management services, warehousing and inventory transportation, field services and mobilization, sustaining engineering, maintenance, repair and overhaul supplies, and on-going weapon maintenance and technical assistance. The group specializes in rebuilding essential parts and assemblies. Customers include the U.S. military as well as commercial and international customers.

 

AEROSPACE

 

Integrated Systems

The Integrated Systems segment, headquartered in El Segundo, California, designs, develops, produces, and supports fully missionized integrated systems and subsystems in the areas of battlespace awareness, command and control systems, integrated combat systems, and airborne ground surveillance. The segment is organized into the following areas of business: Integrated Systems Western Region (ISWR); Airborne Early Warning & Electronic Warfare (AEW/EW) Systems; and Airborne Ground Surveillance & Battle Management (AGS/BM) Systems.

 

Integrated Systems Western Region – The principal manned programs in ISWR are subcontractor work on the F/A-18 and F-35 programs and prime contract work on the B-2 program and the Multi-Platform Radar Technology Insertion Program (MP-RTIP). For the F/A-18, ISWR is responsible for the full integration of the center and aft fuselage and vertical tail sections and associated subsystems. For the F-35, ISWR is responsible for the detailed design and integration of the center fuselage and weapons bay, systems engineering, mission system software, ground and flight test support, signature/low observables development, and support of modeling and simulation activities. ISWR is the prime systems integration contractor for the MP-RTIP, which will provide advanced radar capabilities for both the Global Hawk UAV and the latest U.S. Air Force Multi Sensor Command and Control Aircraft (E-10A). ISWR is working on a radar and avionics upgrade program for the B-2 bomber and is a prime integrator for all logistics support activities including program depot maintenance.

 

The principal unmanned programs at ISWR are the Global Hawk, the Naval Unmanned Combat Air System (N-UCAS), Aerial Targets, and the Fire Scout. ISWR is the prime contractor for these product lines with the exception of the Army version of Fire Scout for Future Combat Systems (FCS). The Global Hawk is a high altitude long endurance unmanned aerial reconnaissance system. N-UCAS is a competitive development program designed to demonstrate the technical feasibility, military utility, and operational value for a networked system of high performance and weaponized UAVs to effectively and affordably prosecute 21st century combat missions. Aerial Targets has two primary models, the BQM-74 and the BQM-34 and is the prime contractor on multiple domestic and international contracts. Fire Scout is a vertical takeoff and landing tactical UAV system in development and consists of two versions – the Vertical Takeoff and Landing Unmanned Air Vehicle (VTUAV) for the U.S. Navy and the FCS Class IV UAV for the U.S. Army.

 

Airborne Early Warning & Electronic Warfare Systems – AEW System’s principal products include the E-2C Hawkeye and E-2D Advanced Hawkeye aircraft (currently in the system development and demonstration, or SDD, phase of development). The Hawkeye is the U.S. Navy’s airborne battle management command and control mission system providing airborne early warning detection, identification, tracking, targeting, and communication capabilities. The company has recently completed delivering E-2C aircraft to the U.S. Navy and international customers under the current multi-year contract, and is currently performing on a follow-on multi-year contract for eight additional aircraft to be delivered to the U.S. Navy through 2009 (2 aircraft delivered in 2006). The company is developing the next generation capability including radar, mission computer, vehicle, and other system enhancements called the E-2D Advanced Hawkeye under an SDD contract with the U.S. Navy.

 

EW System’s principal products include the EA-6B (Prowler) and EA-18G electronic attack aircraft. The Prowler is currently the armed services’ only offensive tactical radar jamming aircraft. EW Systems has developed the next generation mission system for this aircraft under the Increased Capacity (ICAP) III contract and has completed the final test and evaluation phase. The company completed the low-rate initial production for ICAP III Kits

 

NORTHROP GRUMMAN CORPORATION

during 2006, and was awarded a follow-on contract for ICAP III Kits & Spares, with deliveries commencing in 2007. In addition, the company is performing on a contract to incorporate the ICAP III mission system into an F/A-18 platform, designated the EA-18G. Integrated Systems is the principal subcontractor to Boeing for this program, which is currently in the SDD phase.

 

Airborne Ground Surveillance & Battle Management Systems – AGS/BM Systems is the prime contractor on the Joint Surveillance Target Attack Radar System (Joint STARS) program. Joint STARS detects, locates, classifies, tracks, and targets potentially hostile ground movement in all weather conditions. It is designed to operate around the clock in constant communication through secure data links with U.S. Air Force command posts, U.S. Army mobile ground stations, or centers for military analysis far from the point of conflict. With all the production deliveries complete, Joint STARS has shifted toward higher development upgrades, retrofits, and support of the existing fleet. The Total Support Systems Responsibility (TSSR) program provides management services and sustains Joint STARS aircraft and associated systems. A follow-on system, the E-10A Technology Demonstration Development Program is currently on contract to modify a Boeing 767-400ER Platform to demonstrate the MP-RTIP Radar and some Battle Management Command & Control (BMC2) functionality via selective test flights and demonstrations. AGS/BM Systems is actively involved in the Mine Counter Measures (MCM) technology with multiple customers and contracts that focus on detecting and neutralizing in-land, coastal and water surface/subsurface mines. AGS/BM Systems is aligned with five NATO partners in the Alliance Ground Surveillance Joint Venture for the NATO Design and Development phase of NATO’s manned/unmanned ground surveillance program. AGS/BM Systems is bidding on the KC-135 Tanker Replacement program.

 

Space Technology

The Space Technology segment, headquartered in Redondo Beach, California, develops a broad range of systems at the leading edge of space, defense, and electronics technology. The sector provides products primarily for the U.S. Government that contribute significantly to the nation’s security and leadership in science and technology. Space Technology primarily consists of the following areas of business: Intelligence, Surveillance & Reconnaissance (ISR); Civil Space; Software Defined Radios (which was transferred to the Mission Systems segment effective January 1, 2007); Satellite Communications (SatCom); Missile & Space Defense; and Technology.

 

Intelligence, Surveillance & Reconnaissance – The ISR business area, gives the nation’s monitoring systems a global reach and enhanced national security. Addressing requirements in space-based intelligence, surveillance, and reconnaissance systems, ISR provides mission and system engineering, satellite systems, and mission operations. Customers are predominantly restricted, as are the major programs. The Defense Support Program (DSP) is also part of this business area, and has been monitoring ballistic missile launches for the U.S. Air Force for decades.

 

Civil Space – The Civil Space business area produces and integrates space-based systems, instruments, and services primarily for the NASA, the National Oceanic and Atmospheric Administration, and other governmental agencies. These systems are primarily used for space science, earth observation and environmental monitoring, and exploration missions. A variety of systems and services are provided, including mission and system engineering services, spacecraft and instrument systems, mission operations, and propulsion systems. Major programs include National Polar-orbiting Operational Environmental Satellite System (NPOESS), the James Webb Space Telescope (JWST), Geostationary Operational Environmental Satellite (GOES-R), and the legacy Chandra space telescope and Earth Observing System programs.

 

Software Defined Radios – Space Technology’s Software Defined Radios business area is at the forefront of radio technology, and designs, develops, and produces advanced integrated Communications, Navigation and Identification (CNI) systems, radios, and avionics integration software. The sector’s avionics systems are integral elements of the F-22A and F-35.

 

Satellite Communications – The SatCom business area includes complex satellite communication payloads. Key customers are satellite prime contractors in support of the DoD and other government agencies. Major programs

 

NORTHROP GRUMMAN CORPORATION

include the Advanced Extremely High Frequency (AEHF) payload, Transformational Satellite (TSAT) communications system, and the communication payload for the legacy Milstar program, currently in operation.

 

Missile & Space Defense – The Missile & Space Defense business area produces space, air, and ground-based systems that detect, track, and destroy missiles. Key capabilities and products include system integration, spacecraft design and development, and high energy laser systems and subsystems. Primary customers include the Missile Defense Agency (MDA), the U.S. Air Force, the U.S. Army, and other prime contractors. Major programs include the Space Tracking and Surveillance System (STSS) and Airborne Laser (ABL).

 

Technology – The Technology business area consists primarily of government funded research and development contracts in support of the five business areas described above.

 

ELECTRONICS

 

The Electronics segment, headquartered in Linthicum, Maryland, develops, produces, integrates and supports high performance sensors, intelligence processing, and navigation systems operating in all environments from undersea to outer space and cyberspace. It also develops, produces, integrates and supports power, power control, and ship controls for commercial and naval ships. It provides systems direct to end user customers in domestic and international markets. In select markets it performs as a prime contractor, integrating multiple subsystems to provide complete systems to meet customers’ solution requirements. The segment is composed of five areas of business: Aerospace Systems; Defensive Systems; Government Systems; Naval & Marine Systems; and Navigation Systems.

 

Aerospace Systems – Aerospace Systems provides sensors, sensor processing, integrated sensor suites, and radar countermeasure systems for military surveillance and precision-strike; missile tracking and warning; space satellite applications; and radio frequency electronic warfare. Fire control radars include systems for the F-16, F-22A, F-35 and B-1B. Navigation radars include commercial and military systems for cargo aircraft. Airborne surveillance systems include the Airborne Warning and Control System (AWACS) radar, the 737 Multi-Role Electronically Scanned Array (MESA), the MP-RTIP and Multi-mission Maritime Aircraft (MMA). Space satellite products include the Space-Based Infrared Surveillance (SBIRS) program, payloads for restricted programs, the Defense Meteorological Satellite Program (DMSP), NPOESS, and the DSP. Radio frequency electronic warfare products include radar warning receivers, self-protection jammers, and integrated electronic warfare systems for aircraft such as the Prowler, F-16 and F-15.

 

Defensive Systems – Defensive Systems provides systems that support combat aviation by protecting aircraft and helicopters from attack, by providing capabilities for precise targeting and tactical surveillance, by improving mission availability through automated test systems and by improving mission skills through advanced simulation systems. It also provides systems that support land forces. Aircraft and helicopter protection systems include infrared detection and countermeasures systems to defeat shoulder-launched and infrared-guided missiles. Targeting systems include lasers for target designation and image processing and sensor applications, and the LITENING pod system to detect and designate targets for engagement by precision weapons in aircraft such as the F-16 and F/A-18. Test systems include systems to test electronic components of combat aircraft on the flight line and in repair facilities. Land force systems include precision guided munitions for artillery and UAV delivery, night vision goggles, laser designators, weapon sights, tactical radars for warning of missile and artillery attack, and fire control radars for helicopters. Defensive Systems also provides standard simulators for use on test ranges and training facilities to emulate radars of potential adversaries.

 

Government Systems – Government Systems provides products and services to meet the needs of governments for improvements in the effectiveness of their civil and military infrastructure and of their combat and counter-terrorism operations. This includes systems and systems integration of products and services for postal automation, for the detection and alert of Chemical, Biological, Radiological, Nuclear and Explosive (CBRNE) material, for homeland defense, communications, and air traffic management, and for multi-sensor processing and analysis for combat units and national agencies of data from ISR systems. Key programs include: Advanced Flat

 

NORTHROP GRUMMAN CORPORATION

Sorting Machines; International Sorting Centers; air to ground radios, voice and data switches, ground movement and landing systems; U.S. Postal Service bio-detection systems; robots for bomb disposal; national level communications, information processing and air defense systems for international customers; unattended ground sensors; the ISR Distributed Common Ground System for the U.S. military services and national agencies; and deployed ISR and persistent surveillance processing systems.

 

Naval & Marine Systems – Naval and Marine Systems provides major subsystems and subsystem integration for sensors, sensor processing, missile launching, ship controls and power generation. It provides systems to military surface and subsurface platforms, and bridge and power control systems for commercial maritime applications. Principal programs include: radars for navigation; radars for aircraft and cruise missile defense; bridge management and control systems; power generation systems for aircraft carriers; propulsion systems for the Virginia Class submarine; launch systems for Trident submarines and the KEI program; the Advanced SEAL Delivery System mini-submarine; and unmanned semi-autonomous naval systems.

 

Navigation Systems – Navigation Systems provides navigation, identification and avionics systems for military and commercial applications. Its products are used in commercial space and aircraft; in military air, land, sea, and space systems; and in both U.S. and international markets. Key programs include: integrated avionics for the U.S. Marine Corps attack and utility helicopters and U.S. Navy E-2 aircraft; military navigation and positioning systems for the F-16 fighter, F-22A fighter/attack aircraft, Eurofighter, and U.S. Navy MH-60 helicopter; navigation systems for commercial aircraft; navigation systems for military and civil space satellites and deep space exploration; friend-or-foe transponders and interrogators; and systems for the C-17 aircraft, Eurofighter and MH-60 helicopter. Navigation Systems also develops and produces fiber-optic acoustic systems for underwater surveillance for Virginia Class submarines.

 

SHIPS

 

The Ships segment includes the following areas of business: Aircraft Carriers; Expeditionary Warfare; Surface Combatants; Submarines; Coast Guard & Coastal Defense; Services; and Commercial & Other.

 

Aircraft Carriers – Ships is the nation’s sole industrial designer, builder, and refueler of nuclear-powered aircraft carriers. The U.S. Navy’s newest carrier, the USS Ronald Reagan, was delivered to the fleet in May 2004. Construction on the last carrier in the Nimitz class, the George H. W. Bush, continues. The Bush christening occurred in the fall of 2006 and delivery to the U.S. Navy is expected in 2008. Advanced design and preparation continues for the new generation carrier, CVN 21, which will incorporate transformational technologies that will result in manning reductions, improved war fighting capability, and a new nuclear propulsion plant design. The construction award for the first ship of the CVN 21 program, the Gerald R. Ford, is expected in early 2008. The company also provides ongoing maintenance for the U.S. Navy aircraft carrier fleet through overhaul, refueling, and repair work. Ships is currently performing the refueling and complex overhaul of the USS Carl Vinson with redelivery to the U.S. Navy anticipated in early 2009. Planning for the USS Theodore Roosevelt refueling and complex overhaul began in the fall of 2006. The ship is expected to arrive at Newport News, Virginia in the fall of 2009.

 

Expeditionary Warfare – Expeditionary Warfare programs include the design and construction of amphibious assault ships for the U.S. Navy, including the WASP LHD 1 class and the San Antonio LPD 17 class. Ships is the sole provider for the LHD class of large-deck, 40,500-ton multipurpose amphibious assault ships, which serve as the centerpiece of an Amphibious Ready Group. Currently, the LHD 8 is under construction and is a significant upgrade from the preceding seven ships of its class. The design and production of the LHD 8 is a $1.8 billion program with delivery scheduled for 2008. In 2006, design & long lead construction funding was awarded for the LHA 6, the first in a new class of enhanced amphibious assault ships, and the construction award is anticipated in the first half of 2007. Ships is also the sole provider of the LPD 17 class of ships, which function as amphibious transports. The initial two ships were delivered in 2005 and 2006, and five LPD 17 ships are currently under construction. Also, one additional ship is in backlog and long lead funding has been received on the ninth ship.

 

NORTHROP GRUMMAN CORPORATION

Surface Combatants – Surface Combatants includes the design and construction of the Arleigh Burke DDG 51 class Aegis guided missile destroyers, and the design of DDG 1000 (previously DD(X)), the Navy’s future transformational surface combatant class. Ships is one of two prime contractors designing and building DDG 51 class destroyers, which provide primary anti-aircraft and anti-missile ship protection for the U.S. Navy fleet. Three Arleigh Burke class destroyers are currently under construction with an additional ship in backlog. In 2006, Ships was awarded Phase IV detail design & long lead construction funding for the initial DDG 1000. The contract calls for an equal split of ship detail design efforts between the company and Bath Iron Works, a wholly owned subsidiary of General Dynamics Corporation. The construction award for the initial ship is anticipated in the first half of 2007. The advanced technologies developed on DD(X) Phase III are being incorporated into DDG 1000 and are expected to be incorporated into the next generation guided missile cruiser CG(X).

 

Submarines – Northrop Grumman is one of only two U.S. companies capable of designing and building nuclear-powered submarines. In February 1997, the company and Electric Boat, a wholly owned subsidiary of General Dynamics Corporation, reached an agreement to cooperatively build Virginia Class nuclear attack submarines. The lead ship, USS Virginia, was delivered by Electric Boat to the U.S. Navy and commissioned into the fleet in October 2004. The USS Texas was delivered by Ships in the spring of 2006. The Hawaii was delivered in December 2006, and progress continues on the North Carolina, the final block one ship. Electric Boat and Ships were awarded a construction contract in August 2003, which was subsequently modified in January 2004, for the second block of six Virginia Class submarines. Planning and long lead material procurement is underway on all six boats of the second block; construction has begun on the first four.

 

Coast Guard & Coastal Defense – Ships is a joint venture partner along with Lockheed Martin for the Coast Guard’s Deepwater Modernization Program. Ships has design and production responsibility for all surface ships, including three new classes of cutters. The program is a 20-year program with the surface ship content having an estimated revenue value of over $8 billion. In 2006, the Ships/Lockheed Martin joint venture was selected for a 43 month contract extension for the Deepwater program.

 

Services – Ships provides after-market services, including on-going maintenance and repair work, for a wide array of naval and commercial vessels. The company has ship repair facilities in the U.S. Navy’s largest homeports of Norfolk, Virginia, and San Diego, California.

 

Commercial & Other – Under the Polar Tanker program, Ships was under contract to produce five double-hulled tankers. These tankers each transport one million barrels of crude oil from Alaska to west coast refineries and are fully compliant with the Oil Pollution Act of 1990. The last ship under this program was delivered in mid-2006.

 

Corporate

The company’s principal executive offices are located at 1840 Century Park East, Los Angeles, California 90067. The company’s telephone number is (310) 553-6262. The company’s home page on the Internet is www.northropgrumman.com. The company makes web site content available for informational purposes, and such content is not incorporated by reference into this Form 10-K, unless so specified herein.

 

NORTHROP GRUMMAN CORPORATION

 

SUMMARY SEGMENT FINANCIAL DATA

 

In the following table, revenue from the U.S. Government includes revenue from contracts for which Northrop Grumman is the prime contractor, as well as those for which the company is a subcontractor and the ultimate customer is the U.S. Government. The company’s discontinued operations are excluded from all of the data elements in this table. For a more complete understanding of the company’s financial information, see the “Segment Operating Results” in Part II, Item 7, and the consolidated financial statements in Part II, Item 8.

 

 

NORTHROP GRUMMAN CORPORATION

Foreign Sales – Foreign sales amounted to approximately $1.6 billion, $1.7 billion, and $1.6 billion, or 5.2 percent, 5.5 percent, and 5.5 percent of total revenue for the years ended December 31, 2006, 2005, and 2004, respectively. All of the company’s segments engage in international business, for which the company retains a number of sales representatives and consultants who are not employees of the company. See “Risk Factors” in Part I, Item 1A.

 

 

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

 

Net Pension Expense Adjustment – The net pension expense adjustment reflects the excess pension expense determined in accordance with accounting principles generally accepted in the United States of America (GAAP) over the pension expense allocated to the operating segments under CAS.

 

Realignments

The company, from time to time, acquires or disposes of businesses, and realigns contracts, programs or business areas among its operating segments that possess similar customers, expertise, and capabilities. These realignments are designed to more fully leverage existing capabilities and enhance development and delivery of products and services. The operating results for all periods presented have been revised to reflect these changes.

 

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Other Financial Information

 

 

NORTHROP GRUMMAN CORPORATION

 

Substantially all of the company’s assets are located or maintained in the United States. Backlog is converted into the following years’ sales as costs are incurred or deliveries are made. Approximately 65 percent of the 2006 year-end funded backlog is expected to be converted into sales in 2007.

 

CUSTOMERS AND REVENUE CONCENTRATION

 

The company’s primary customer is the U.S. Government. Revenue from the U.S. Government accounted for approximately 90 percent, 90 percent, and 88 percent of total revenues in 2006, 2005, and 2004, respectively. No other customer accounted for more than 10 percent of total revenue during any period presented. No single product or service accounted for more than 10 percent of total revenue during any period presented.

 

NORTHROP GRUMMAN CORPORATION

 

PATENTS

 

The following table summarizes the number of patents the company owns or has pending as of December 31, 2006:

 

 

Patents developed while under contract with the U.S. Government may be subject to use by the U.S. Government. In addition the company licenses intellectual property to, and from, third parties. Management believes the company’s ability to conduct its operations would not be materially affected by the loss of any particular intellectual property right.

 

SEASONALITY

 

No material portion of the company’s business is considered to be seasonal. The timing of revenue recognition is determined upon several factors including the timing of contract awards, the incurrence of contract costs, cost estimation, and unit deliveries. See “Revenue Recognition” in Part II, Item 7.

 

RAW MATERIALS

 

The most significant raw material required by the company is steel, used primarily for ship building. The company has mitigated supply risk by negotiating long-term agreements with a number of steel suppliers. In addition, the company has mitigated price risk related to its steel purchases through certain contractual arrangements with the U.S. Government. While the company has generally been able to obtain key raw materials required in its production processes in a timely manner, a significant delay in receipt of these supplies by the company could have a material effect on the company’s results of operations. See “Risk Factors” in Part I, Item 1A.

 

GOVERNMENT REGULATION

 

The company’s business is affected by numerous laws and regulations relating to the award, administration and performance of U.S. Government contracts. See “Risk Factors” in Part I, Item 1A.

 

Certain programs with the U.S. Government that are prohibited by the customer from being publicly discussed in detail are referred to as “restricted” in this Form 10-K. The consolidated financial statements and financial information contained within this Form 10-K reflect the operating results of restricted programs under GAAP. See “Risk Factors” in Part I, Item 1A.

 

RESEARCH AND DEVELOPMENT

 

Company-sponsored research and development activities primarily include independent research and development (IR&D) efforts related to government programs. IR&D expenses are included in general and administrative expenses and are allocated to U.S. Government contracts. Company-sponsored research and development expenses totaled $574 million, $538 million, and $504 million in 2006, 2005, and 2004, respectively. Expenses for research and development sponsored by the customer are charged directly to the related contracts.

 

NORTHROP GRUMMAN CORPORATION

 

EMPLOYEE RELATIONS

 

The company believes that it maintains good relations with its 122,200 employees, of which approximately 19 percent are covered by 32 collective bargaining agreements. The company expects to re-negotiate two of its larger collective bargaining agreements and 15 of its smaller agreements in 2007. It is not expected that these negotiations will, either individually or in the aggregate, have a material adverse effect on the company’s results of operations. See “Risk Factors” in Part I, Item 1A.

 

ENVIRONMENTAL MATTERS

 

Federal, state, and local laws relating to the protection of the environment affect the company’s manufacturing operations. The company has provided for the estimated cost to complete environmental remediation where the company has determined it is probable that the company will incur such costs in the future to address environmental impacts at currently or formerly owned or leased operating facilities, or at sites where it has been named a Potentially Responsible Party (PRP) by the Environmental Protection Agency or similarly designated by other environmental agencies. These estimates may change given the inherent difficulty in estimating environmental cleanup costs to be incurred in the future due to the uncertainties regarding the extent of the required cleanup, determination of legally responsible parties, and the status of laws, regulations, and their interpretations.

 

In order to assess the potential impact on the company’s financial statements, management estimates the possible remediation costs that reasonably could be incurred by the company on a site-by-site basis. Such estimates take into consideration the professional judgment of the company’s environmental engineers and, when necessary, consultation with outside environmental specialists. In most instances, only a range of reasonably possible costs can be estimated. However, in the determination of accruals, the most probable amount is used when determinable, and the minimum is used when no single amount is more probable. The company records accruals for environmental cleanup costs in the accounting period in which the company’s responsibility is established and the costs can be reasonably estimated. The company does not anticipate and record insurance recoveries before it has determined that collection is probable.

 

Management estimates that at December 31, 2006, the range of reasonably possible future costs for environmental remediation sites is $224 million to $319 million, of which $257 million is accrued in “Other current liabilities” in the consolidated statements of financial position. Environmental accruals are recorded on an undiscounted basis. At sites involving multiple parties, the company provides environmental accruals based upon its expected share of liability, taking into account the financial viability of other jointly liable parties. Environmental expenditures are expensed or capitalized as appropriate. Capitalized expenditures relate to long-lived improvements in currently operating facilities. In addition, 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, which could have a material effect on the company’s consolidated financial position, results of operations, or cash flows. The company has made the investments it believes necessary in order to comply with environmental laws.

 

COMPETITIVE CONDITION

 

Northrop Grumman, along with Lockheed Martin Corporation, The Boeing Company, Raytheon Company, and General Dynamics Corporation are among the largest companies in the U.S. defense industry at this time. Northrop Grumman competes against these and other companies for a number of programs, both large and small. Intense competition and long operating cycles are both key characteristics of Northrop Grumman’s business and the defense industry. It is common in this industry for work on major programs to be shared among a number of companies. A company competing to be a prime contractor may, upon ultimate award of the contract to another party, turn out to be a subcontractor for the ultimate prime contracting party. It is not uncommon to compete for a contract award with a peer company and, simultaneously perform as a supplier to or a customer of such competitor on other contracts. The nature of major defense programs, conducted under

 

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binding contracts, allows companies that perform well to benefit from a level of program continuity not common in many industries.

 

The company’s success in the competitive defense industry depends upon its ability to develop and market its products and services, as well as its ability to provide the people, technologies, facilities, equipment, and financial capacity needed to deliver those products and services with maximum efficiency. It is necessary to maintain, as the company has, sources for raw materials, fabricated parts, electronic components, and major subassemblies. In this manufacturing and systems integration environment, effective oversight of subcontractors and suppliers is as vital to success as managing internal operations. See “Risk Factors” in Part I, Item 1A.

 

EXECUTIVE OFFICERS

 

See Part III, Item 10, for information about Executive Officers of the company.

 

AVAILABLE INFORMATION

 

Throughout this Form 10-K, the company incorporates by reference information from parts of other documents filed with the Securities and Exchange Commission (SEC). The SEC allows the company to disclose important information by referring to it in this manner, and you should review this information in addition to the information contained herein.

 

The company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and proxy statement for the annual shareholders’ meeting, as well as any amendments to those reports, are available free of charge through the company’s web site as soon as reasonably practicable after electronic filing of such material with the SEC. You can learn more about the company by reviewing the company’s SEC filings on the company’s web site. The company’s SEC reports can be accessed through the investor relations page of the company’s web site at www.northropgrumman.com.

 

The SEC also maintains a web site at www.sec.gov that contains reports, proxy statements and other information regarding SEC registrants, including Northrop Grumman. The public may read and copy any materials filed by the company with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

 

 

 

Approximately 90 percent of the company’s revenues during 2006 were derived from products and services ultimately sold to the U.S. Government and are therefore affected by, among other things, the federal budget process. The company is a supplier, either directly or as a subcontractor or team member, to the U.S. Government and its agencies as well as foreign governments and agencies. These contracts are subject to the respective customers’ political and budgetary constraints and processes, changes in customers’ short-range and long-range strategic plans, the timing of contract awards, and in the case of contracts with the U.S. Government, the congressional budget authorization and appropriation processes, the Government’s ability to terminate contracts for convenience or for default, as well as other risks such as contractor

 

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suspension or debarment in the event of certain violations of legal and regulatory requirements. The termination or failure to fund one or more significant contracts by the U.S. Government could have a material adverse effect on the company’s results of operations or prospects.

 

In the event of termination for the government’s convenience, contractors are normally protected by provisions covering reimbursement for costs incurred subsequent to termination. The company is involved in a lawsuit concerning a contract terminated for convenience. See “Other Matters” in Part I, Item 3. Termination resulting from the company’s default could expose the company to liability and have a material adverse effect on its ability to compete for contracts.

 

In addition, a material amount of the company’s revenues and profits is derived from programs that are subject to security classification restrictions (restricted business), which could limit the company’s ability to discuss details about these programs, their risks or any disputes or claims relating to such programs. As a result, investors might have less insight into the company’s restricted business than other businesses of the company or could experience less ability to evaluate fully the risks, disputes or claims associated with restricted business.

 

The company’s success in the competitive defense industry depends upon its ability to develop and market its products and services, as well as its ability to provide the people, technologies, facilities, equipment, and financial capacity needed to deliver those products and services with maximum efficiency. A loss of business to our competitors could have a material adverse affect on the company’s ability to generate favorable financial results and maintain market share.

 

 

The company designs, develops and manufactures technologically advanced and innovative products and services applied by our customers in a variety of environments. Problems and delays in development or delivery as a result of issues with respect to design, technology, licensing and patent rights, labor, learning curve assumptions, or materials and components could prevent the company from achieving contractual requirements.

 

In addition, the company’s products cannot be tested and proven in all situations and are otherwise subject to unforeseen problems. Examples of unforeseen problems which could negatively affect revenue and profitability include loss on launch of spacecraft, premature failure, problems with quality, country of origin, delivery of subcontractor components or services, and unplanned degradation of product performance. These failures could result, either directly or indirectly, in loss of life or property. Among the factors that may affect revenue and profits could be unforeseen costs and expenses not covered by insurance or indemnification from the customer, diversion of management focus in responding to unforeseen liabilities, loss of follow-on work, and, in the case of certain contracts, repayment to the government customer of contract cost and fee payments previously received by the company.

 

Certain contracts, primarily involving space satellite systems, contain provisions that entitle the customer to recover fees in the event of partial or complete failure of the system upon launch or subsequent deployment for less than a specified period of time. Under such terms, the company could be required to forfeit fees previously recognized and/or collected. The company has not experienced any material losses in the last decade in connection with contract performance incentive provisions. However, if the company were to experience launch failures or complete satellite system failures in the future, such events could have a material adverse impact on the company’s financial position or results of operations.

 

NORTHROP GRUMMAN CORPORATION

 

 

Operating margin is adversely affected when contract costs that cannot be billed to customers are incurred. This cost growth can occur if estimates to complete increase due to technical challenges or if initial estimates used for calculating the contract price were incorrect. The cost estimation process requires significant judgment and expertise. Reasons for cost growth may include unavailability and productivity of labor, the nature and complexity of the work to be performed, the effect of change orders, the availability of materials, the effect of any delays in performance, availability and timing of funding from the customer, natural disasters, and the inability to recover any claims included in the estimates to complete. A significant change in cost estimates on one or more programs could have a material effect on the company’s consolidated financial position or results of operations.

 

Due to their nature, fixed-price contracts inherently have more risk than flexibly priced contracts and therefore generally carry higher profit margins. Approximately 34 percent of the company’s annual revenues are derived from fixed-price contracts – see “Contracts” in Part II, Item 7. Flexibly priced contracts may carry risk to the extent of their specific contract terms and conditions relating to performance award fees and negative performance incentives. The company typically enters into fixed-price contracts where costs can be reasonably estimated based on experience. In addition, certain contracts other than fixed-price contracts have provisions relating to cost controls and audit rights. Should the terms specified in those contracts not be met, then profitability may be reduced.

 

Fixed-price development work comprises a small portion of the company’s fixed-price contracts and inherently has more uncertainty as to future events than production contracts and therefore more variability in estimates of the costs to complete the development stage. As work progresses through the development stage into production, the risks associated with estimating the total costs of the contract are generally reduced. In addition, successful performance of fixed-price development contracts, which include production units, is subject to the company’s ability to control cost growth in meeting production specifications and delivery rates. While management uses its best judgment to estimate costs associated with fixed-price development programs, future events could result in either upward or downward adjustments to those estimates. Examples of the company’s significant fixed-price development contracts include the F-16 Block 60 combat avionics program and the MESA radar system program for the Wedgetail and Peace Eagle contracts, both of which are performed by the Electronics segment. It is also not unusual in the Ships business for the company to negotiate fixed-price production follow-on contracts before the development effort has been completed and learning curves fully realized on existing flexibly priced development contracts.

 

 

Contract accounting requires judgment relative to assessing risks, estimating contract revenues and costs, and making assumptions for schedule and technical issues. Due to the size and nature of many of the company’s contracts, the estimation of total revenues and costs at completion is complicated and subject to many variables. For example, assumptions have to be made regarding the length of time to complete the contract because costs also include expected increases in wages and prices for materials. Similarly, assumptions have to be made regarding the future impact of efficiency initiatives and cost reduction efforts. Incentives, awards, or penalties related to performance on contracts are considered in estimating revenue and profit rates, and are recorded when there is sufficient information to assess anticipated performance.

 

Because of the significance of the judgments and estimation processes described above, it is possible that materially different amounts could be obtained if different assumptions were used or if the underlying circumstances were to change. Changes in underlying assumptions, circumstances or estimates may have a

 

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material adverse effect upon future period financial reporting and performance. See “Critical Accounting Policies, Estimates, and Judgments” in Part II, Item 7.

 

 

The company has thousands of contracts and operations in many parts of the world subject to U.S. and foreign laws and regulations. Prime contracts with various agencies of the U.S. Government and subcontracts with other prime contractors are subject to numerous procurement regulations, including the False Claims Act and the International Traffic in Arms Regulation promulgated under the Arms Export Control Act, with noncompliance found by any one agency possibly resulting in fines, penalties, debarment, or suspension from receiving additional contracts with all U.S. Government agencies. Given the company’s dependence on U.S. Government business, suspension or debarment could have a material adverse effect on the company.

 

In addition, international business subjects the company to numerous U.S. and foreign laws and regulations, including, without limitation, regulations relating to import-export control, technology transfer restrictions, repatriation of earnings, exchange controls, the Foreign Corrupt Practices Act, and the anti-boycott provisions of the U.S. Export Administration Act. Failure by the company or its sales representatives or consultants to comply with these laws and regulations could result in administrative, civil, or criminal liabilities and could, in the extreme case, result in suspension or debarment from government contracts or suspension of the company’s export privileges, which could have a material adverse effect on the company. Changes in regulation or political environment may affect the company’s ability to conduct business in foreign markets including investment, procurement, and repatriation of earnings.

 

The company operates in a highly regulated environment and is routinely audited by the U.S. Government and others. On a regular basis, the company monitors its policies and procedures with respect to its contracts to ensure consistent application under similar terms and conditions and to assess compliance with all applicable government regulations. Negative audit findings could result in termination of a contract, forfeiture of profits, or suspension of payments. From time to time the company is subject to U.S. Government investigations relating to its operations. Government contractors that are found to have violated the law such as the False Claims Act or the Arms Export Control Act, or are indicted or convicted for violations of other federal laws, or are found not to have acted responsibly as defined by the law, may be subject to significant fines. Such convictions could also result in suspension or debarment from government contracting for some period of time. Given the company’s dependence on government contracting, suspension or debarment could have a material adverse effect on the company.

 

 

The company may be affected by delivery or performance issues with key suppliers and subcontractors, as well as other factors that may cause operating results to be adversely affected. Changes in inventory requirements or other production cost increases may also have a negative effect on the company’s consolidated results of operations.

 

Performance failures by a subcontractor of the company or difficulty in maintaining complete alignment of the subcontractor’s obligations with the company’s prime contract obligations may adversely affect the company’s ability to perform its obligations on the prime contract, which could reduce the company’s profitability due to damages or other costs that may not be fully recoverable from the subcontractor or from the customer and could result in a termination of the prime contract and have an adverse effect on the company’s ability to compete for future contracts.

 

NORTHROP GRUMMAN CORPORATION

 

The company has significant operations located in regions of the U.S. where damaging storms and other natural disasters are somewhat common. While preventative measures typically help to minimize harm to the company, the damage and disruption resulting from certain storms or other natural disasters may be significant. Although no assurances can be made, the company believes it can recover costs associated with natural disasters through insurance or its contracts.

 

Natural disasters such as storms and earthquakes can disrupt electrical and other power distribution networks and cause adverse effects on profitability and performance, including computer and internet operation and accessibility. Computer viruses and similar harmful software programs, as well as network outages, disruptions and attacks also may have a material adverse affect on the company’s profitability and performance unless quarantined or otherwise prevented.

 

 

As part of its overall strategy, the company will, from time to time, acquire a minority or majority interest in a business. These investments are made upon careful target analysis and due diligence procedures designed to achieve a desired return or strategic objective. These procedures often involve certain assumptions and judgment in determining acquisition price. After acquisition, unforeseen issues could arise which adversely affect the anticipated returns or which are otherwise not recoverable as an adjustment to the purchased price. Even after careful integration efforts, actual operating results may vary significantly from initial estimates.

 

Goodwill accounts for approximately half of the company’s recorded total assets. The company evaluates the recoverability of recorded goodwill amounts annually, or when evidence of potential impairment exists. The annual impairment test is based on several factors requiring judgment. Principally, a decrease in expected reporting unit cash flows or changes in market conditions may indicate potential impairment of recorded goodwill. See “Critical Accounting Policies, Estimates, and Judgments” in Part II, Item 7.

 

 

The size and complexity of the company’s business make it highly susceptible to claims and litigation. The company is subject to environmental claims, income tax matters and other litigation, which, if not resolved within established accruals, could have a material adverse effect on the company’s consolidated financial position, results of operations, or cash flows. See “Legal Proceedings” in Part I, Item 3, and “Critical Accounting Policies, Estimates, and Judgments” in Part II, Item 7.

 

 

A substantial portion of the company’s current and retired employee population is covered by pension and post-retirement benefit plans, the costs of which are dependent upon the company’s various assumptions, including estimates of rates of return on benefit related assets, discount rates for future payment obligations, rates of future cost growth and trends for future costs. Variances from these estimates could have a material adverse affect on the company’s consolidated financial position, results of operations, and cash flows.

 

NORTHROP GRUMMAN CORPORATION

 

 

Primarily as a result of the major hurricanes in 2004 and 2005 (including Hurricanes Katrina and Rita), market conditions have substantially changed, resulting in an overall reduced amount of total available coverage. The company endeavors to identify and obtain in established markets insurance agreements to cover significant risks and liabilities (including, among others, natural disasters, products liability and business interruption). Not every risk or liability can be protected against by insurance, and, for insurable risks, the limits of coverage reasonably obtainable in the market may not be sufficient to cover all actual losses or liabilities incurred. In some, but not all, circumstances the company may receive indemnification from the U.S. Government. Because of the reduction in overall available coverage referred to above, the company may have to bear substantial costs for uninsured losses that could have an adverse effect upon its consolidated results of operations and its overall consolidated financial position. Additionally, disputes with insurance carriers over coverage may affect the timing of cash flows and, where litigation with the carrier becomes necessary, an outcome unfavorable to the company may have a material adverse affect on the company’s consolidated results of operations. See Note 15 to the consolidated financial statements in Part II, Item 8.

 

 

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

 

The company has no unresolved comments from the SEC.

 

FORWARD-LOOKING STATEMENTS AND PROJECTIONS

 

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

 

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

 

Forward-looking statements are based upon, among other things, the company’s assumptions with respect to:

 

 

NORTHROP GRUMMAN CORPORATION

 

 

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

 

At December 31, 2006, the company had approximately 55 million square feet of floor space comprised of approximately 2,164 buildings/structures and land at 504 separate locations, primarily in the U.S., for the purpose of manufacturing, warehousing, research and testing, administration and various other productive and facility uses. Of the total square footage at December 31, 2006, 55 percent was company-owned, 41 percent was leased and 4 percent was government-owned or leased. At December 31, 2006, the company leased to other third parties approximately 1,014,000 square feet of its owned and leased facilities, and had vacant floor space of approximately 680,000 square feet.

 

At December 31, 2006, our business operating segments had major operations at the following locations:

 

Mission Systems – Huntsville, AL; Carson, Huntington Beach, McClellan, Redondo Beach, San Bernardino, San Diego, San Jose, San Pedro, Van Nuys and West Sacramento, CA; Aurora and Colorado Springs, CO; Washington, DC; Columbia, Elkridge and Lanham, MD; Bellevue, NE; Fairborn and Kettering, OH; Middletown, RI; Clearfield, UT; Arlington, Chantilly, Chester, Dahlgren, Fairfax, Herndon, Newport News, Reston, Stafford, Vienna and Virginia Beach, VA.

 

Information Technology – Hawthorne, CA; Colorado Springs and Lafayette, CO; Washington, DC; Atlanta, GA; Andover, MA; Annapolis Junction and Rockville, MD; Bethpage and Bohemia, NY; Fairborn, OH; Dallas and Irving, TX; Arlington, Chantilly, Fairfax, Falls Church, Herndon, Lorton, McLean, Reston, and Richmond, VA.

 

Technical Services – Sierra Vista, AZ; Warner Robins, GA; Lake Charles, LA; Albuquerque, NM; and Oklahoma City, OK.

 

Integrated Systems – Carson, El Segundo, Tejon, Hawthorne, Palmdale, and San Diego, CA; Jacksonville, Melbourne and St. Augustine, FL; Hollywood, MD; Moss Point, MS; New Town, ND; and Bethpage, NY.

 

NORTHROP GRUMMAN CORPORATION

 

Space Technology – El Segundo, Manhattan Beach, Rancho Carmel, Redondo Beach and San Diego, CA; St. Charles, MO; and Charlotte, NC.

 

Electronics – Huntsville, AL; Tempe, AZ; Azusa, San Jose, Sunnyvale and Woodland Hills, CA; Boulder, CO; Norwalk, CT; Apopka, FL; Rolling Meadows, IL; Westwood, MA; Annapolis, Annapolis Junction, Baltimore, Belcamp, Elkridge, Gaithersburg, Hagerstown, Linthicum and Sykesville, MD; Springfield, MO; Ocean Springs, MS; Melville and Williamsville, NY; Cincinnati, OH; Clinton, TN; Garland, TX; Salt Lake City, UT; and Charlottesville, VA. Locations outside the U.S .include France, Germany, Italy, Norway, and the United Kingdom.

 

Ships – San Diego, CA; Avondale, Harahan, Harvey, Tallulah and Waggaman, LA; Gautier, Gulfport, Moss Point and Pascagoula, MS; and Newport News, VA.

 

Corporate and other locations – Brea, San Pedro, and Los Angeles, CA; Des Plaines, IL; Olathe, KS; Englewood and Hanover Township, NJ; York, PA; Irving and Marshall, TX; and Arlington, VA. Locations outside the U.S. include Canada and the United Kingdom.

 

The following is a summary of the company’s floor space at December 31, 2006:

 

 

The company believes its properties are well maintained and in good operating condition and that the productive capacity of the company’s properties is adequate to meet current contractual requirements and those for the foreseeable future.

 

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

 

NORTHROP GRUMMAN CORPORATION

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 2006 to cover the cost of the settlement proposal and associated investigative costs. The charge has been recorded within “General and administrative expenses” in the consolidated statements of income in Part II, Item 8. 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.

 

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, 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 trial date has been set for May 22, 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 U.S. 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 (ERISA) 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). 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.

 

On January 3, 2007, a class action lawsuit was filed in the U.S. District Court, Central District of California, against the company, certain of its administrative and Board committees, certain members of its Board of Directors, and certain company officers and employees (Heidecker v. Northrop Grumman Corporation, et al.). The lawsuit alleges two alternative counts of fiduciary duty breaches under ERISA with respect to the investment

 

NORTHROP GRUMMAN CORPORATION

and administrative management of the Northrop Grumman Savings Plan, including allegations of excessive, hidden and/or otherwise improper fee and expense charges. 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.

 

Other Matters

In the event of contract termination for the government’s convenience, contractors are normally protected by provisions covering reimbursement for costs incurred on the program. The company received a termination for convenience notice on the Tri-Service Standoff Attack Missile (TSSAM) program in 1995. In December 1996, the company filed a lawsuit against the U.S. Government in the U.S. Court of Federal Claims seeking the recovery of approximately $750 million for uncompensated performance costs, investments and a reasonable profit on the program. Prior to 1996, the company had charged to operations in excess of $600 million related to this program. Northrop Grumman is unable to predict whether it will realize some or all of its claims, none of which are recorded on its balance sheet, from the U.S. Government related to the TSSAM program.

 

No items were submitted to a vote of security holders during the fourth quarter of 2006.

 

 

The company’s common stock is listed on the New York Stock Exchange.

 

The following table sets forth, for the periods indicated, the high and low sale prices of the company’s common stock as reported in the consolidated reporting system for the New York Stock Exchange Composite Transactions:

 

 

 

The approximate number of common shareholders was 37,467 as of February 16, 2007.

 

 

Quarterly dividends per common share for the most recent two years are as follows:

 

 

NORTHROP GRUMMAN CORPORATION

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.

 

The quarterly dividend for the mandatorily redeemable preferred shares was $1.75 for each quarter in 2006 and 2005.

 

Common Stock

The company has 800,000,000 shares authorized at a $1 par value, of which 345,921,809 and 347,357,291 shares were outstanding as of December 31, 2006 and 2005, respectively.

 

Preferred Stock

The company has 10,000,000 shares authorized with a liquidation value of $100 per share, of which 3,500,000 shares were outstanding as of December 31, 2006 and 2005.

 

 

The Annual Meeting of Stockholders of Northrop Grumman Corporation will be held on May 16, 2007, at the Space Technology Presentation Center, One Space Park, Redondo Beach, California 90278.

 

 

COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN

AMONG NORTHROP GRUMMAN CORPORATION, S & P 500 INDEX

AND S & P AEROSPACE/DEFENSE INDEX

 

 

 

 

NORTHROP GRUMMAN CORPORATION

 

 

No repurchases of the company’s equity securities were made during the fourth quarter of 2006.

 

NORTHROP GRUMMAN CORPORATION

 

The data presented in the following table has been adjusted to reflect the current application of discontinued operations as well as the two-for one stock split of the company’s common stock in 2004. See also “Business Acquisitions” and “Business Dispositions” in Part II, Item 7.

 

Selected Financial Data

 

 

 

NORTHROP GRUMMAN CORPORATION

 

Business

Northrop Grumman provides technologically advanced, innovative products, services, and integrated solutions in information and services, aerospace, electronics, and shipbuilding to its global customers. As a system integrator, 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 (DoD). The company also conducts business with foreign governments and makes domestic and international commercial sales.

 

Outlook

U.S. defense contractors have benefited from the upward trend in overall defense spending over recent years. Certain programs in which the company participates may be subject to potential reductions due to a slower rate of growth in the U.S. Defense Budget forecasts and funds being diverted to support the on-going Global War on Terrorism and the reordering of priorities by the DOD. Despite this trend, the company believes that its portfolio of technologically advanced, innovative products, services, and integrated solutions in systems integration, defense electronics, information technology, advanced aircraft, shipbuilding, technical services and space technology will generate revenue growth in 2007 and beyond. In 2007, based on total backlog (funded and unfunded) of approximately $61 billion as of December 31, 2006, the company expects sales to range between $31 and $32 billion and forecasts improvement in net income over 2006. The major industry and economic factors that may affect the company’s future performance are described in the following paragraphs.

 

Industry Factors

While Northrop Grumman is subject to the usual vagaries of the defense marketplace, it is also affected by the unique characteristics of the defense industry as a monopsony, and by certain elements peculiar to its own business mix. Northrop Grumman, along with Lockheed Martin Corporation, The Boeing Company, Raytheon Company, and General Dynamics Corporation are among the largest companies in the U.S. defense industry at this time. Northrop Grumman competes against these and other companies for a number of programs, both large and small. Intense competition and long operating cycles are both key characteristics of Northrop Grumman’s business and the defense industry. It is common in this industry for work on major programs to be shared among a number of companies. A company competing to be a prime contractor may, upon ultimate award of the contract to another party, turn out to be a subcontractor for the ultimate prime contracting party. It is not uncommon to compete for a contract award with a peer company and simultaneously perform as a supplier to or a customer of such competitor on other contracts. The nature of major defense programs, conducted under binding contracts, allows companies that perform well to benefit from a level of program continuity not common in many industries.

 

The company’s success in the competitive defense industry depends upon its ability to develop and market its products and services, as well as its ability to provide the people, technologies, facilities, equipment, and financial capacity needed to deliver those products and services with maximum efficiency. It is necessary to maintain, as the company has, sources for raw materials, fabricated parts, electronic components, and major subassemblies. In this manufacturing and systems integration environment, effective oversight of subcontractors and suppliers is as vital to success as managing internal operations.

 

Economic Opportunities, Challenges, and Risks

The defense of the U.S. and its allies requires the ability to respond to one or more regional conflicts, terrorist acts, or threats to homeland security, and is increasingly dependent upon early threat identification. National responses to those threats may require unilateral or cooperative initiatives ranging from dissuasion, deterrence, active defense, security and stability operations, or peacekeeping. The U.S. government continues to place a high priority on the protection of its engaged forces and citizenry, and in minimizing collateral damage when force

 

NORTHROP GRUMMAN CORPORATION

must be applied in pursuit of national objectives. As a result, the U.S. and its military coalitions increasingly rely on sophisticated systems providing long-range surveillance and intelligence, battle management, and precision strike capabilities combined with the ability to rapidly deploy effective force to any region. Accordingly, defense procurement spending is expected to be weighted toward the development and procurement of military platforms and systems demonstrating the stealth, long-range, survivability, persistence and standoff capabilities that can overcome such obstacles to access. Additionally, advanced electronics and software that enhance the capabilities of individual systems and provide for the real-time integration of individual surveillance, information management, strike, and battle management platforms will also be required.

 

While the upward trend in overall defense spending may slow, U.S. budgets are expected to continue to exhibit real growth in the coming years. While defense spending in allied countries may not match that growth, many of those allies are focusing their development and procurement efforts on advanced electronics and information systems capabilities to enhance their interoperability with U.S. forces. Of note, the 2006 Quadrennial Defense Review increased the DoD focus on intelligence, surveillance, and reconnaissance (ISR), and joint command and control, in support of future budget submissions. The size of future U.S. and international defense budgets is expected to remain responsive to the international security environment. The 2008 budget submitted by the President requests $481.4 billion in discretionary authority for the DoD base budget (including $141.7 billion to continue the fight in the Global War on Terrorism), representing an 11.3 percent increase over the projected enacted level for fiscal 2007. While this budget includes proposed reductions in certain programs in which the company participates or for which the company expects to compete, the company believes that spending on recapitalization and transformation of homeland security and defense assets will continue to be a national priority, with particular emphasis on areas involving intelligence and non-conventional warfare capabilities.

 

U.S. Government programs in which Northrop Grumman either participates, or strives to participate, must compete with other programs for consideration during our nation’s budget formulation and appropriation processes. Budget decisions made in this environment will have long-term consequences for the size and structure of Northrop Grumman and the entire defense industry. Despite significant growth in the defense budget since 2001, the percent of Gross Domestic Product dedicated to the nation’s defense has remained relatively constant.

 

Substantial new competitive opportunities for the company include a new aerial refueling tanker, the next-generation long-range bomber, space radar, unmanned vehicles, transformational satellite communications systems, restricted space-based programs, technical services and information technology contracts, and several international and homeland security programs. In pursuit of these opportunities, Northrop Grumman continues to focus on operational and financial performance for continued growth in 2007 and beyond.

 

Northrop Grumman has historically concentrated its efforts in high technology areas such as stealth, airborne surveillance, battle management, systems integration, defense electronics, and information technology. The company has a significant presence in federal and civil information systems; the manufacture of combatant ships including aircraft carriers and submarines; space technology; command, control, communications, computers, intelligence, surveillance, and reconnaissance (C4ISR) and missile systems. The company believes that its programs are a high priority for national defense. Nevertheless, under budgetary pressures and emphasis on capabilities to conduct non-conventional warfare, there remains the possibility that one or more of them may be reduced, extended, or terminated by our U.S. Government customers.

 

The company provides certain product warranties that require repair or replacement of non-conforming items for a specified period of time. Most of the company’s product warranties are provided under government contracts, the costs of which are generally incorporated into contract pricing.

 

Prime contracts with various agencies of the U.S. Government and subcontracts with other prime contractors are subject to numerous procurement regulations, including the False Claims Act and The International Traffic in Arms Regulations promulgated under the Arms Export Control Act, with noncompliance found by any one agency possibly resulting in fines, penalties, debarment, or suspension from receiving additional contracts with all

 

NORTHROP GRUMMAN CORPORATION

U.S. Government agencies. Given the company’s dependence on U.S. Government business, suspension or debarment could have a material adverse effect on the company.

 

2006 – In October the company announced its intent to acquire Essex Corporation (Essex). On January 25, 2007, the company completed its purchase of 100 percent of the common stock of Essex, valued at approximately $600 million, including the assumption of debt totaling $23 million and estimated transaction costs of $14 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 will be included as part of the Mission Systems segment from the date of acquisition. The assets, liabilities, and results of operations of Essex were not material.

 

2005 – The company acquired Confluent RF Systems Corporation (Confluent) for $42 million, which included transaction costs of $2 million, and Integic Corporation (Integic) for $319 million, which included transaction costs of $6 million. The assets, liabilities, and results of operations of these acquired businesses were not material individually or in the aggregate, and thus pro-forma information is not presented.

 

2004 – There were no significant acquisitions during 2004.

 

2006 – The company sold the assembly business unit of Interconnect Technologies (Interconnect) and Winchester Electronics (Winchester) for net cash proceeds of $26 million and $17 million, respectively, and recognized an after-tax gain of $4 million and $3 million, respectively, in discontinued operations. The results of operations of Interconnect 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 (EIT) 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 statements of income, net of applicable income taxes, for all periods presented.

 

2005 – The company sold Teldix GmbH (Teldix) for $57 million in cash and recognized an after-tax gain of $14 million in discontinued operations. 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.

 

2004 – The company’s Canadian navigation systems and space sensors systems business and Kester were sold for cash of $65 million and $60 million, respectively, and the company recorded an after-tax gain of $12 million and $2 million, respectively, in discontinued operations. The results of operations of these businesses were not material to any of the periods presented and have therefore not been reclassified as discontinued operations.

 

The majority of the company’s business is generated from long-term government contracts for development, production, and service activities. Government contracts typically include the following cost elements: direct material, labor and subcontracting costs, and certain indirect costs including allowable general and administrative costs. Unless otherwise specified in a contract, costs billed to contracts with the U.S. Government are determined under the requirements of the Federal Acquisition Regulation (FAR) and Cost Accounting Standards (CAS) regulations as allowable and allocable costs. Examples of costs incurred by the company and not billed to the U.S. Government in accordance with the requirements of the FAR and CAS regulations include, but are not limited to, certain legal costs, lobbying costs, charitable donations, and advertising costs.

 

NORTHROP GRUMMAN CORPORATION

 

The company’s long-term contracts typically fall into one of two broad categories:

 

Flexibly Priced Contracts – Includes both cost-type and fixed-price incentive contracts. Cost-type contracts provide for reimbursement of the contractor’s allowable costs incurred plus a fee that represents profit. Cost-type contracts generally require that the contractor use its best efforts to accomplish the scope of the work within some specified time and some stated dollar limitation. Fixed-price incentive contracts also provide for reimbursement of the contractor’s allowable costs, but are subject to a cost-share limit which affects profitability. Fixed-price incentive contracts effectively become firm fixed-price contracts once the cost-share limit is reached.

 

Firm Fixed-Price Contracts – A firm fixed-price contract is a contract in which the specified scope of work is agreed to for a price that is a pre-determined, negotiated amount and not generally subject to adjustment regardless of costs incurred by the contractor.

 

The following table summarizes 2006 revenue recognized by contract type and customer:

 

 

Contract Fees – Negotiated contract fee structures, for both flexibly priced and fixed-price contracts may include, but are not limited to: fixed-fee amounts, cost sharing arrangements to reward or penalize for either under or over cost target performance, positive award fees, and negative penalty arrangements. Profit margins may vary materially depending on the negotiated contract fee arrangements, percentage-of-completion of the contract, the achievement of performance objectives, and the stage of performance at which the right to receive fees, particularly under incentive and award fee contracts, is finally determined.

 

Positive Award Fees – Certain contracts contain provisions consisting of award fees based on performance criteria such as: cost, schedule, quality, and technical ingenuity. Award fees are determined and earned based on the subjective evaluation by the customer of the company’s performance against such negotiated criteria. Award fee contracts are widely used throughout the company’s operating segments. Examples of significant long-term contracts with substantial negotiated award fee amounts are the Kinetic Energy Interceptor (KEI), F-35 SDD, E-2D SDD, LPD, and DDG-1000 programs.

 

Compliance and Monitoring – On a regular basis, the company monitors its policies and procedures with respect to its contracts to ensure consistent application under similar terms and conditions as well as compliance with all applicable government regulations. In addition, costs incurred and allocated to contracts with the U.S. Government are routinely audited by the Defense Contract Audit Agency.

 

The company’s significant accounting policies are outlined in Note 1 to the consolidated financial statements (see in Part II, Item 8 of this Form 10-K). The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expenses, as well as the disclosure of contingent assets and liabilities. As part of its oversight responsibilities, management evaluates the propriety of its estimates, judgments, and accounting methods as new events occur. Management believes that its policies, judgments, and assessments have been consistently applied in a manner that provides the reader of the company’s consolidated financial statements with a fair presentation of information, in all material respects, in accordance with GAAP. Management periodically reviews the company’s critical accounting policies and estimates with the audit committee of its board of directors. Principal accounting practices that involve a higher degree of judgment or complexity are outlined below.

 

NORTHROP GRUMMAN CORPORATION

 

Revenue Recognition

Overview – The majority of the company’s business is derived from long-term contracts for the construction of facilities, production of goods, and services provided to the federal government, which are accounted for under the provisions of Accounting Research Bulletin No. 45 – Accounting for Long-Term Construction-Type Contracts, American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) No. 81-1 – Accounting for Performance of Construction-Type and Certain Production-Type Contracts, and the AICPA Audit and Accounting Guide, Audits of Federal Government Contractors. The Company classifies contract revenues as product sales or service revenues depending on the predominant attributes of the relevant underlying contracts.

 

The company also enters into contracts that are not associated with the construction of facilities, production of goods, and services provided to the federal government, such as contracts to provide certain services to non-federal government customers. The company accounts for those contracts in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, Revenue Recognition, and other relevant revenue recognition accounting literature.

 

The company considers the nature of these contracts and the types of products and services provided when it determines the proper accounting method for a particular contract.

 

Percentage-of-Completion Accounting – The company generally recognizes revenue from its long-term contracts under the cost-to-cost and the units-of-delivery measures of the percentage-of-completion method of accounting. The percentage-of-completion method recognizes income as work on a contract progresses. For most contracts, sales are calculated based on the percentage of total costs incurred in relation to total estimated costs at completion of the contract. For certain contracts with large up-front purchases of material, primarily in the Ships segment, sales are generally calculated based on the percentage that direct labor costs incurred bear to total estimated direct labor costs. The units-of-delivery measure is a modification of the percentage-of-completion method, which recognizes revenues as deliveries are made to the customer generally using unit sales value in accordance with the contract terms. The company estimates profit as the difference between total estimated revenue and total estimated cost of a contract and recognizes that profit evenly over the life of the contract based on deliveries.

 

The use of the percentage-of-completion method depends on the ability of the company to make reasonably dependable cost estimates for the design, manufacture, and delivery of its products and services. Such costs are typically incurred over a period of several years, and estimation of these costs requires the use of judgment. Sales under cost-type contracts are recorded as costs are incurred.

 

Many contracts contain positive and negative profit incentives based upon performance relative to predetermined targets that may occur during or subsequent to delivery of the product. These incentives take the form of potential additional fees to be earned or penalties to be incurred. Incentives and award fees that can be reasonably estimated are recorded over the performance period of the contract. Incentives and award fees that cannot be reasonably estimated are recorded when awarded or at such time as a reasonable estimate can be made.

 

Other changes in estimates of contract sales, costs, and profits are recognized using the cumulative catch-up method of accounting. This method recognizes in the current period the cumulative effect of the changes on current and prior periods. Hence, the effect of the changes on future periods of contract performance is recognized as if the revised estimates had been the original estimates. A significant change in an estimate on one or more programs could have a material effect on the company’s financial position or results of operations.

 

Certain Service Contracts – Revenue under contracts to provide services to non-federal government customers are generally recognized when services are performed. Service contracts include operations and maintenance contracts, and outsourcing-type arrangements, primarily in the Information and Services business. Revenue under such contracts is generally recognized on a straight-line basis over the period of contract performance, unless evidence suggests that the revenue is earned or the obligations are fulfilled in a different pattern. Costs incurred under these service contracts are expensed as incurred, except that direct and incremental set-up costs

 

NORTHROP GRUMMAN CORPORATION

are capitalized and amortized over the life of the agreement. Operating profit related to such service contracts may fluctuate from period to period, particularly in the earlier phases of the contract.

 

Service contracts that include more than one type of product or service are accounted for under the provisions of Emerging Issues Task Force Issue No. 00-21 – Revenue Arrangements with Multiple Deliverables. Accordingly, for applicable arrangements, revenue recognition includes the proper identification of separate units of accounting and the allocation of revenue across all elements based on relative fair values.

 

Cost Estimation – The cost estimation process requires significant judgment and is based upon the professional knowledge and experience of the company’s engineers, program managers, and financial professionals. Factors that are considered in estimating the work to be completed and ultimate contract recovery include the availability and productivity of labor, the nature and complexity of the work to be performed, the effect of change orders, the availability of materials, the effect of any delays in performance, availability and timing of funding from the customer, and the recoverability of any claims included in the estimates to complete. A significant change in an estimate on one or more programs could have a material effect on the company’s financial position or results of operations. Contract cost estimates are updated at least annually and more frequently as determined by events or circumstances. Cost and revenue estimates for each significant contract are generally reviewed and reassessed quarterly.

 

When estimates of total costs to be incurred on a contract exceed estimates of total revenue to be earned, a provision for the entire loss on the contract is recorded to cost of sales in the period the loss is determined. Loss provisions are first offset against costs that are included in inventoried assets, with any remaining amount reflected in liabilities.

 

Purchase Accounting and Goodwill

Overview – The purchase price of an acquired business is allocated to the underlying tangible and intangible assets acquired and liabilities assumed based upon their respective fair market values, with the excess recorded as goodwill. Such fair market value assessments require judgments and estimates that can be affected by contract performance and other factors over time, which may cause final amounts to differ materially from original estimates. Adjustments to fair value assessments are recorded to goodwill over the purchase price allocation period (typically not exceeding a twelve month period) with the exception of certain adjustments related to income tax uncertainties or restructuring activities, the resolution of which may extend beyond the purchase price allocation period.

 

Acquisition Accruals – The company has established certain accruals in connection with indemnities and other contingencies from its acquisitions and divestitures. These accruals and subsequent adjustments have been recorded during the purchase price allocation period for acquisitions and as events occur for divestitures. The accruals were determined based upon the terms of the purchase or sales agreements and, in most cases, involve a significant degree of judgment. Management has recorded these accruals in accordance with its interpretation of the terms of the purchase or sale agreements, known facts, and an estimation of probable future events based on management’s experience and consultation with outside valuation specialists.

 

Goodwill – The company evaluates the recoverability of recorded goodwill amounts annually in November, or when evidence of potential impairment exists, in accordance with Statement of Financial Accounting Standards (SFAS) No. 142 – Goodwill and Other Intangible Assets. In order to test for potential impairment, the company uses a discounted cash flow analysis, corroborated by comparative market multiples where appropriate.

 

The principal factors used in the discounted cash flow analysis requiring judgment are the projected results of operations, weighted average cost of capital (WACC), and terminal value growth rate assumptions. The WACC takes into account the relative weights of each component of the company’s consolidated capital structure (equity and debt) and represents the expected cost of new capital adjusted as appropriate to consider lower risk profiles associated with longer term contracts and barriers to market entry. The terminal value growth rates are applied to the final year of the discounted cash flow model.

 

NORTHROP GRUMMAN CORPORATION

 

Due to the many variables inherent in the estimation of a reporting unit’s fair value and the relative size of the company’s recorded goodwill, differences in assumptions may have a material effect on the results of the company’s impairment analysis.

 

Litigation, Commitments, and Contingencies

Overview – The company is subject to a range of claims, lawsuits, environmental and income tax matters, and administrative proceedings that arise in the ordinary course of business. Estimating liabilities and costs associated with these matters requires judgment and assessment based upon professional knowledge and experience of management and its internal and external legal counsel. In accordance with SFAS No. 5, Accounting for Contingencies, amounts 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 such exposure to the company may vary from earlier estimates as further facts and circumstances become known.

 

While the company cannot predict the ultimate outcome of these matters, resolution of one or more of these matters, either individually or in the aggregate, could have a material effect on the company’s financial position, results of operations, or cash flows.

 

Environmental Accruals – The company is subject to the environmental laws and regulations of the jurisdictions in which it conducts operations. The company records an accrual to provide for the costs of expected environmental obligations when management becomes aware that an expenditure will be incurred and the amount of the liability can be reasonably estimated. Factors which could result in changes to the company’s assessment of probability, range of loss, and environmental accruals include: modification of planned remedial actions, increase or decrease in the estimated time required to remediate, discovery of more extensive contamination than anticipated, results of efforts to determine legally responsible parties, changes in laws and regulations affecting remediation requirements, and improvements in remediation technology.

 

Litigation Accruals – 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.

 

Tax Contingency Accruals – The company records accruals for tax contingencies and related interest when it is probable that a liability has been incurred and the amount of the contingency can be reasonably estimated based on specific events such as an audit or inquiry by a taxing authority. Changes in accruals associated with uncertainties arising from pre-acquisition years for acquired businesses are charged or credited to goodwill. Adjustments to other tax accruals are generally recorded in earnings in the period they are determined. Effective January 1, 2007, the company will measure and record tax contingency accruals in accordance with Financial Accounting Standards Board Interpretation No. 48 – Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109. See Note 2 to the consolidated financial statements in Part II, Item 8.

 

Retirement Benefits

Overview – Assumptions used in determining projected benefit obligations and the fair values of plan assets for the company’s pension plans and other postretirement benefits plans are evaluated annually by management in consultation with its outside actuaries. In the event that the company determines that plan amendments or changes in the assumptions are warranted, future pension and postretirement benefit expenses could increase or decrease.

 

Assumptions – The principal assumptions that have a significant effect on the company’s financial position and results of operations are the discount rate, the expected long-term rate of return on plan assets, and the health care cost trend rates.

 

NORTHROP GRUMMAN CORPORATION

 

Discount Rate – The discount rate represents the interest rate that should be used to determine the present value of future cash flows currently expected to be required to settle the pension and postretirement benefit obligations. The discount rate is generally based on the yield on high-quality corporate fixed-income investments. At the end of each year, the discount rate is primarily determined based on the results of a hypothetical long-term bond portfolio matching the expected cash inflows with the expected benefit payments for each benefit plan. Taking into consideration the factors noted above, the company’s composite discount rate was 6 percent at December 31, 2006, and 5.75 percent at December 31, 2005.

 

Expected Long-Term Rate of Return – The expected long-term rate of return on plan assets represents the average rate of earnings expected on the funds invested to provide for anticipated future benefit payment obligations. For 2006 and 2005, the company assumed an expected long-term rate of return on plan assets of 8.5 percent.

 

Changes in the discount rate and expected long-term rate of return on plan assets within the range indicated below would have had the following impacts on 2006 pension and other postretirement benefits results:

 

 

Health Care Cost Trend Rates – The health care cost trend rates represent the annual rates of change in the cost of health care benefits based on estimates of health care inflation, changes in health care utilization or delivery patterns, technological advances, and changes in the health status of the plan participants. For 2006, the company assumed an expected initial health care cost trend rate of 8.75 percent and an ultimate health care cost trend rate of 5 percent. In 2005, the company assumed an expected initial health care cost trend rate of 10 percent and an ultimate health care cost trend rate of 5 percent.

 

Differences in the initial through the ultimate health care cost trend rates within the range indicated below would have had the following impact on 2006 postretirement benefit results:

 

 

The company manages and assesses the performance of its business primarily through the following measures:

 

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

 

Sales – Year-to-year sales vary less than contract acquisitions and reflect performance under new and ongoing contracts. For further information related to revenue recognition, refer to the Revenue Recognition discussion included in the “Critical Accounting Policies, Estimates, and Judgments” section of this Part II, Item 7.

 

NORTHROP GRUMMAN CORPORATION

 

Segment Operating Margin – Segment operating margin reflects the performance of segment contracts and programs. Excluded from this measure are certain costs not directly associated with contract performance, including the portion of corporate expenses such as management and administration, legal, environmental, certain compensation and retiree benefits, and other expenses not considered allowable or allocable under applicable CAS regulations and the Federal Acquisition Regulation, and therefore not allocated to the segments.

 

Backlog – Funded backlog represents unfilled orders for which funding has been contractually obligated by the customer. Unfunded backlog represents firm orders for which funding is not contractually obligated by the customer. Unfunded backlog excludes unexercised contract options and unfunded Indefinite Delivery Indefinite Quantity (IDIQ) orders. For multi-year services contracts with non-federal government customers having no stated contract values, backlog includes only the amounts committed by the customer.

 

Selected financial highlights are presented in the table below.

 

 

Sales and Service Revenues

2006 – Sales in 2006 increased $81 million as compared with 2005. The increase was primarily due to increased revenues in the Information Technology and Technical Services segments, partially offset by decreased revenues at the Ships segment. Information Technology segment sales increased $260 million due to new business primarily from the Virginia and San Diego County information technology outsourcing contracts and higher sales volume in the United Kingdom Whole Life Support Programme and the Systems and Software Engineering Services program. Technical Services segment revenues increased $256 million primarily due to new business from the Nevada Test Site program. Ships segment sales decreased $465 million due primarily to decreased volume in the DDG 1000 program (formerly known as the DD(X) program) and continued recovery from the impact of Hurricane Katrina (See Note 17 to the consolidated financial statements in Part II, Item 8).

 

2005 – Sales in 2005 increased $1.1 billion, or 4 percent, over 2004 due to increased revenue in each of the company’s operating segments except Ships, including sales growth of 19 percent at Integrated Systems. The increase at Integrated Systems was due primarily to higher volume in the E-2D Advanced Hawkeye, EA-18G, Unmanned Systems, B-2, and Multi-Platform Radar Technology Insertion Program (MP-RTIP) programs, partially offset by lower volume in the F/A-18 and Joint STARS programs. Ships segment sales decreased 7 percent in 2005 due primarily to decreased volume in the DDG 1000 and LHD programs and Hurricane Katrina-related work delays.

 

NORTHROP GRUMMAN CORPORATION

 

Operating Margin

Operating Margin represents segment operating margin (see section entitled “Segment Operating Results”) adjusted for a number of factors that do not affect the segments as follows:

 

 

Unallocated Expenses – Unallocated expenses increased $97 million, or 51 percent, in 2006 as compared with 2005. The increase in unallocated expenses is primarily due to a $112.5 million pre-tax legal provision recorded in 2006 (see Note 15 to the consolidated financial statements in Part II, Item 8). Unallocated expenses decreased $92 million, or 33 percent, in 2005 as compared with 2004. The decrease was primarily due to lower legal costs in 2005, as the 2004 legal costs included provisions related to the resolution of the Allison Gas Turbine and Robinson litigations.

 

Also included in unallocated expenses is the cost of medical and life benefits to the extent not currently recoverable under CAS. In November 2006, the company adopted plan amendments and communicated to plan participants that it would cap the amount of its contributions to substantially all of its remaining post retirement medical and life benefit plans that were previously not subject to limits on the company’s contributions. The change in benefits announced in November 2006 reduced benefit costs by approximately $17 million in 2006. In addition, this change reduced the company’s aggregate benefit obligation by approximately $465 million at December 31, 2006. Subsequent to January 1, 2005 (or earlier at some sectors), newly hired employees are not eligible for post employment medical and life benefits.

 

Net Pension Expense Adjustment – The net pension expense adjustment reflects the excess pension expense determined in accordance with GAAP over the pension expense allocated to the operating segments under CAS. The net pension expense adjustment increased to $37 million in 2006, as compared with $21 million in 2005, and increased $9 million in 2005 as compared with 2004. Both increases reflect the timing of cost recognition between GAAP and CAS.

 

For 2007, subject to refinements for participant census data and pay-as-you-go plans, management expects the net pension expense adjustment to total approximately $70 million in income primarily due to an increase in the discount rate, voluntary pre-funding during 2006, and higher than expected return on plan assets during 2006. The 2007 pension plan assumptions include an expected long-term rate of return on plan assets of 8.5 percent and a composite discount rate of 6 percent.

 

Reversal of Royalty Income – Royalty income is included in segment operating margin for internal reporting purposes. This amount is reversed in the table above to arrive at operating margin as determined in accordance with GAAP as royalty income is included in the “Other, net” line item discussed below.

 

Net Interest Expense

2006 – Net interest expense decreased $31 million, or 9 percent, in 2006 as compared with 2005. The decrease was primarily due to a lower average debt balance in 2006 resulting from debt maturities totaling $1.2 billion in 2006.

 

2005 – Net interest expense decreased $39 million, or 10 percent, in 2005 as compared with 2004. The decrease was primarily due to a lower average debt balance in 2005 resulting from a $600 million reduction in debt in the fourth quarter of 2004.

 

NORTHROP GRUMMAN CORPORATION

Other, net

2006 – Other, net decreased $75 million, or 38 percent, from 2005 income of $200 million. During 2006, the company sold its remaining 9.7 million TRW Automotive (TRW Auto) shares, generating pre-tax gains of $111 million, which were partially offset by losses on other equity investments.

 

2005 – Other, net increased $218 million from 2004 expense of $18 million due primarily to the sale of 7.3 million TRW Auto shares and approximately 3.4 million Endwave shares, which generated pre-tax gains of $70 million and $95 million, respectively.

 

Federal and Foreign Income Taxes

2006 – The company’s effective tax rate on income from continuing operations for 2006 was 31 percent. During 2006, the company received final approval from the U.S. congress Joint Committee on Taxation for the agreement previously reached with the Internal Revenue Service (IRS) regarding its audits of the company’s B-2 program for the years ended December 31, 1997 through December 31, 2000. As a result of the agreement the company recognized tax benefits of $48 million, due to the reversal of previously established expense provisions. The company also recognized a net tax benefit of $18 million in 2006 related to tax credits associated with qualified wages paid to employees affected by Hurricane Katrina. The effective tax rate for 2007 is expected to be between 33 and 34 percent.

 

2005 – The company’s effective tax rate on income from continuing operations for 2005 and 2004 was 32 percent. During 2005, the company recognized a $20 million net tax benefit primarily related to the settlement of IRS appeals cases related to Alternative Minimum Tax credits for tax years 1981 through 1996.

 

Discontinued Operations

2006 – Discontinued operations is primarily comprised of a $19 million after-tax loss on the shutdown of EIT.

 

2005 – Discontinued operations is primarily comprised of a $14 million after-tax gain on the divestiture of Teldix, partially offset by a $9 million after-tax operating loss of EIT.

 

Diluted Earnings per Share

2006 – Diluted earnings per share for 2006 was $4.37 per share, an increase of 14 percent from $3.85 per share in 2005. Earnings per share are based on weighted average diluted shares outstanding of 358.6 million for 2006 and 363.2 million for 2005. For 2006, weighted average diluted shares outstanding used to calculate earnings per share has been adjusted to reflect the dilutive impact of the mandatorily redeemable preferred stock.

 

2005 – Diluted earnings per share for 2005 was $3.85 per share, an increase of 30 percent from $2.97 per share in 2004. Earnings per share are based on weighted average diluted shares outstanding of 363.2 million for 2005 and 365.0 million for 2004.

 

Net Cash Provided by Operating Activities

2006 – Net cash provided by operating activities in 2006 decreased $871 million as compared with 2005, primarily due to contributions to the company’s pension plans. Pension plan contributions totaled $1.2 billion in 2006, of which $800 million was voluntarily pre-funded compared with contributions of $415 million in 2005, of which $203 million was voluntarily pre-funded. Cash collected from customers decreased by $231 million, and cash paid to suppliers and employees increased by $302 million in 2006 as compared with 2005.

 

Net cash provided by operating activities for 2006 included the receipt of $100 million of insurance proceeds related to Hurricane Katrina, $60 million of federal and state income tax refunds, and $45 million of interest.

 

2005 – Net cash provided by operating activities in 2005 increased $691 million as compared with 2004, primarily due to the timing of cash receipts and payments. Cash collected from customers increased by $1.5 billion, and cash paid to suppliers and employees increased by $1.2 billion. Net cash from operating activities for 2005 included the receipt of $89 million of insurance proceeds related to Hurricane Katrina, $88 million of federal and state income tax refunds, and $78 million of interest, including interest on a state tax refund for research and development credits for the years 1988 through 1990. These cash inflows were offset by a

 

NORTHROP GRUMMAN CORPORATION

payment of $99 million for a litigation settlement. Net cash provided by operating activities in 2004 included the receipt of $121 million of federal and state income tax refunds, partially offset by payments of $86 million for litigation settlements. Net cash provided by operating activities in 2005 includes contributions to the company’s pension plans totaling $415 million, of which $203 million was voluntarily pre-funded, as compared to contributions of $624 million in 2004, of which $250 million was voluntarily pre-funded.