NORTHROP GRUMMAN CORPORATION OVERVIEW
The following discussion should be read along with the financial statements included in this Form 10-K, as well as Part II, "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Form 10-K for the year endedDecember 31, 2021 ("2021 Annual Report on Form 10-K"). Global Security Environment TheU.S. and its allies continue to face a global security environment of heightened tensions and instability, threats from state and non-state actors, including in particular major global powers, as well as terrorist organizations, increasing nuclear tensions, diverse regional security concerns and political instability. The market for defense products, services and solutions globally is driven by these complex and evolving security challenges, considered in the broader context of political and socioeconomic circumstances and priorities. Our operations and financial performance, as well as demand for our products and services, are impacted by global events, including violence and unrest. The same is true for our suppliers and other business partners. The conflict inUkraine has increased global tensions and instability, highlighted threats and increased global demand, as well as further disrupted global supply chains and added costs. We have experienced a modest increase in demand for certain of our goods and services directly and indirectly related to the conflict in theUkraine . We also have experienced a slight disruption to some of our programs and supply chain, including unanticipated cost growth, as a result of the conflict inUkraine and economic sanctions. However, we do not have sizable business dealings inRussia orUkraine , and do not anticipate significant adverse impacts from the ongoing conflict. More broadly, the conflict inUkraine and threats elsewhere have heightened tensions and highlighted security requirements globally, especially inEurope and the Pacific region, as well as theU.S. We have started to see, and expect to continue to see, increased demand for defense products and services from allies and partner nations, particularly in those areas. We are actively exploring both opportunities and risks.
For further information on the global security environment, including the risks related thereto, see "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Liquidity and Capital Resources," "Quantitative and Qualitative Disclosures About Market Risks" and "Risk Factors."
Global Health and Economic Environment COVID-19 Since at leastMarch 2020 , when it was first characterized as a global pandemic, COVID-19 has dramatically impacted and continues to impact the global health and economic environments, including millions of confirmed cases and deaths, business slowdowns or shutdowns, labor shortfalls, supply chain challenges, regulatory challenges, inflationary pressures and market volatility. We discussed in some detail in our Annual Reports on Form 10-K for the fiscal years endedDecember 31, 2020 and 2021, and subsequentSEC filings, the pandemic, its impacts and risks, and actions taken up to the time of each filing. In this Form 10-K, we provide a further update. In 2022, the pandemic continued to have significant adverse impacts on the global health and macroeconomic environments, particularly with the spread of new variants and other viruses and illnesses, ongoing disruption of the labor force and supply chains, continued inflation, and market volatility and uncertainties. We expect such adverse impacts to continue. However, with extraordinary efforts by our employees, our governments and customers, our partners and our company, direct COVID-19-related impacts on our business generally declined in 2022. While we cannot predict the future course of the pandemic or its consequences, we are not currently assuming significant additional direct COVID-19 related impacts on our business. The company continues to work to monitor and address the pandemic, including its impact on our company, our employees, our customers, our suppliers and our communities. Our goals have been, and continue to be, to keep our employees safe, to lessen the potential adverse impacts, both health and economic, and to continue to position the company for long-term success. Like the communities in which we operate, our actions have varied, and will continue to vary, depending on the spread of COVID-19 and other illnesses, applicable government requirements, and the needs of our stakeholders. Global Economic Environment In part as a result of the COVID-19 pandemic, the global economic environment has experienced, and continues to experience, extraordinary challenges, including high rates of inflation and inflationary pressures; widespread delays and disruptions in supply chains; workforce challenges, including labor shortages (especially in critical skill areas); and market volatility. These macroeconomic factors have contributed, and we expect will continue to contribute, to increased costs, delays and other performance challenges, as well as increased competing demands for limited -30- --------------------------------------------------------------------------------
resources to address such increased costs and other challenges, for our company, our suppliers and partners, and our customers. For example, as discussed in greater detail in Note 12 to the consolidated financial statements, our latest estimated cost to complete the low-rate initial production (LRIP) phase of the B-21 program reflects updated estimates for adverse impacts from these macroeconomic factors, as well as potential opportunities to address them. We continue to work hard to mitigate some of the challenges caused by the current macroeconomic environment on our business, including by taking steps to support our suppliers and small businesses and enhancing our workforce through extensive hiring, development and retention efforts. However, the broader macroeconomic environment, including inflationary pressures and supply chain challenges, continued adversely to affect the company's results for the year endedDecember 31, 2022 . We cannot clearly predict how long these macroeconomic challenges will continue, or how they will change over time, or what additional resources will be available, but we expect to see this challenging macroeconomic environment continue adversely to impact the global economy, our customers, our industry and our company in 2023. In addition, increased interest rates, raising the cost of borrowing for governments, could further impact government spending priorities (in theU.S. and allied countries, in particular), including their demand for defense products. Economic tensions and changes in international trade policies, including higher tariffs on imported goods and materials and renegotiation of free trade agreements, could also further impact the global market for defense products, services and solutions.U.S. Political, Budget and Regulatory Environment OnMarch 15, 2022 , the President signed into law the Consolidated Appropriations Act for FY 2022, which provided full-year funding for federal agencies, including$782 billion for national defense. This represented an approximately$42 billion or 6 percent increase above the budget for FY 2021, approximately$30 billion more than the Administration had initially requested. The Pentagon's portion of the overall national defense budget for FY 2022 was$743 billion . OnMarch 28, 2022 , the President proposed his budget for FY 2023, which included$813 billion for national defense programs, approximately$31 billion or 4 percent higher than what was appropriated in FY 2022. The Pentagon's portion of the overall requested national defense budget was$773 billion . OnDecember 23, 2022 , the President signed the National Defense Authorization Act (NDAA) for FY 2023, which supports approximately$858 billion in FY 2023 funding for national defense,$817 billion of which is for theDoD . In addition, the FY 2023 NDAA grantsDoD discretionary authority under limited circumstances to provide extraordinary relief to contractors to address certain inflationary impacts. Although discussions have occurred,DoD has not yet issued written guidance for how it intends to exercise this authority. OnDecember 29, 2022 , the President signed an Omnibus appropriations act for FY 2023 that provided$858 billion for national defense programs, approximately$45 billion more than the Administration initially requested for FY 2023 and approximately$76 billion or 10 percent higher than what was appropriated in FY 2022. The Pentagon's portion of the overall national defense budget for FY 2023 is$817 billion . It includes up to$1 billion for extraordinary relief in FY 2023. In addition to theU.S. national security spending detailed above, theU.S. has pledged over$100 billion in security assistance to address the ongoing conflict inUkraine across FY 2022 and FY 2023, including approximately$50 billion inDoD spending. Assistance includes transfers of weapons systems fromU.S. inventories, orders for production of additional weapons systems, both to backfillU.S. stockpiles and forUkraine directly, and assistance fromU.S. capabilities. It is difficult to predict the specific course of future defense budgets. Current and future requirements related to the conflict inUkraine , threats in the Pacific regions and other security priorities, as well as global inflation, the national debt, the costs of the pandemic and other domestic priorities, among other things, in theU.S. and globally, will continue to impact our customers' budgets and priorities, and our industry. Current tensions withinCongress and the widerU.S. political environment may also impact defense budgets and government spending more broadly. We believe the current global security environment highlights the significant national security threats to our nation and our allies, and the need for strong deterrence and a robust defense capability. We believe that our capabilities, particularly in space, C4ISR, missile defense, battle management, advanced weapons, survivable aircraft and mission systems should help our customers in theU.S. and globally defend against current and future threats and, as a result, continue to allow for long-term profitable business growth. The Bipartisan Budget Act of 2019 suspended the debt ceiling throughJuly 31, 2021 . InOctober 2021 , the statutory debt limit was increased by$480 billion and, inDecember 2021 , it was further increased by$2.5 trillion , which is -31- --------------------------------------------------------------------------------
currently expected to allow theTreasury Department to finance the government into 2023. InJanuary 2023 , the debt ceiling was reached and theTreasury Department began taking "extraordinary measures" to finance the government and avoid a breach of the debt ceiling. We expect statutory action will be needed in 2023 to increase or suspend the debt ceiling. During the third quarter of 2022, the Creating Helpful Incentives to Produce Semiconductors (CHIPS) Act of 2022, which includes an advanced manufacturing investment tax credit, among other provisions, and the Inflation Reduction Act of 2022, which includes implementation of a new alternative minimum tax and a one percent excise tax on share repurchases, among other provisions, were signed into law. We expect the excise tax on share repurchases to impact us beginning in 2023; however, we do not expect this tax or any other provision of this legislation to have a material impact on our results of operations or cash flows. More broadly, we have seen, and expect to continue to see, an accelerated pace of new rulemakings, new and expanded uses of existing authorities, changing legal rulings and landscapes, and aggressive enforcement actions. These changes and the accelerated pace of change, not only impose additional obligations and risk, but also create further uncertainty regarding our operating environment. The political environment, federal budget, debt ceiling and regulatory environment are expected to continue to be the subject of considerable debate, especially in light of the ongoing conflict inUkraine , the inflationary environment and political tensions. The results of those debates could have material impacts on defense spending broadly and the company's programs in particular. We anticipate that the broader macroeconomic environment, with ongoing inflationary pressures, labor challenges, and supply chain disruption, among other considerations, will continue to play a significant role in the outcome of these debates and, in turn, on our industry and company.
For further information on the risks we face from the current political and economic environment, see "Risk Factors."
Disposition of IT and Mission Support Services Business EffectiveJanuary 30, 2021 (the "Divestiture date"), we completed the sale of our IT and mission support services business (the "IT services divestiture") for$3.4 billion in cash and recorded a pre-tax gain of$2.0 billion . The IT and mission support services business was comprised of the majority of the former IS&S division of Defense Systems (excluding theVinnell Arabia business); select cyber, intelligence and missions support programs, which were part of the former CIMS division of Mission Systems; and the former Space Technical Services business unit of Space Systems. Operating results include sales and operating income for the IT and mission support services business prior to the Divestiture date; therefore, no sales and operating income were recognized for this business during the year endedDecember 31, 2022 .
The company recorded pre-tax profit of the IT and mission support services
business of
Operating Performance Assessment and Reporting We manage and assess our business based on our performance on contracts and programs (typically larger contracts or two or more closely-related contracts). We recognize sales from our portfolio of long-term contracts as control is transferred to the customer, primarily over time on a cost-to-cost basis (cost incurred relative to costs estimated at completion). As a result, sales tend to fluctuate in concert with costs incurred across our large portfolio of contracts. Due to the applicable FAR and CAS requirements that govern ourU.S. government business, most types of costs are allocable toU.S. government contracts. As such, we do not focus on individual cost groupings (such as manufacturing, engineering and design labor, subcontractor, material, overhead and general and administrative (G&A) costs), as much as we do on total contract cost, which is the key driver of our sales and operating income. In evaluating our operating performance, we primarily focus on changes in sales and operating margin rates. Where applicable, significant fluctuations in operating performance attributable to individual contracts or programs, or changes in a specific cost element across multiple contracts, are described in our analysis. Based on this approach and the nature of our operations, the discussion of results of operations below first focuses on our four segments before distinguishing between products and services. Changes in sales are generally described in terms of volume, while changes in operating margin rates are generally described in terms of performance and/or contract mix. For purposes of this discussion, volume generally refers to increases or decreases in sales or cost from production/service activity levels and performance generally refers to non-volume-related changes in profitability, which are typically described in terms of changes in net EAC adjustments. Contract mix generally refers to changes in the ratio of contract type and/or life cycle (e.g., cost-type, fixed-price, development, production, and/or sustainment). -32- --------------------------------------------------------------------------------
CONSOLIDATED OPERATING RESULTS
For purposes of the operating results discussion below, we assess our performance using certain financial measures that are not calculated in accordance with accounting principles generally accepted inthe United States of America ("GAAP" or "FAS"). Organic sales is defined as total sales excluding sales attributable to the company's IT services divestiture. This measure may be useful to investors and other users of our financial statements as a supplemental measure in evaluating the company's underlying sales growth as well as in providing an understanding of our ongoing business and future sales trends by presenting the company's sales before the impact of divestiture activity. Transaction-adjusted net earnings and transaction-adjusted earnings per share (transaction-adjusted EPS) exclude impacts related to the IT services divestiture, including the gain on sale of the business, associated federal and state income tax expenses, transaction costs, and the make-whole premium for early debt redemption. They also exclude the impact of mark-to-market pension and OPB ("MTM") benefit/(expense) and related tax impacts, which are generally only recognized during the fourth quarter. These non-GAAP measures may be useful to investors and other users of our financial statements as supplemental measures in evaluating the company's underlying financial performance by presenting the company's operating results before the non-operational impact of divestiture activity and pension and OPB actuarial gains and losses. These measures are also consistent with how management views the underlying performance of the business as the impact of the IT services divestiture and MTM accounting are not considered in management's assessment of the company's operating performance or in its determination of incentive compensation awards. We reconcile these non-GAAP financial measures to their most directly comparable GAAP financial measures below. These non-GAAP measures may not be defined and calculated by other companies in the same manner and should not be considered in isolation or as an alternative to operating results presented in accordance with GAAP.
Selected financial highlights are presented in the table below:
Year Ended December 31 % Change in
$ in millions, except per share amounts 2022 2021 2020 2022 2021
Sales $ 36,602 $ 35,667 $ 36,799 3 % (3) %
Operating costs and expenses 33,001 31,996 32,734 3 % (2) %Operating costs and expenses as a % of sales 90.2 % 89.7 %
89.0 %
Gain on sale of business - 1,980 - NM NM
Operating income 3,601 5,651 4,065 (36) % 39 %
Operating margin rate 9.8 % 15.8 % 11.0 %
Mark-to-market pension and OPB benefit (expense) 1,232 2,355 (1,034) (48) % (328) %
Federal and foreign income tax expense 940 1,933 539 (51) % 259 %
Effective income tax rate 16.1 % 21.6 % 14.5 %
Net earnings 4,896 7,005 3,189 (30) % 120 %
Diluted earnings per share $ 31.47 $ 43.54 $ 19.03 (28) % 129 %
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NORTHROP GRUMMAN CORPORATION Sales
The tables below reconcile sales to organic sales:
Year Ended December 31
2022 2021
IT services Organic IT services Organic Organic sales %
$ in millions Sales sales sales Sales sales sales change
Aeronautics Systems $ 10,531 $ - $ 10,531 $ 11,259 $ - $ 11,259 (6) %
Defense Systems 5,579 - 5,579 5,776 (106) 5,670 (2) %
Mission Systems 10,396 - 10,396 10,134 (42) 10,092 3 %
Space Systems 12,275 - 12,275 10,608 (16) 10,592 16 %
Intersegment eliminations (2,179) - (2,179) (2,110) 2 (2,108)
Total $ 36,602 $ - $ 36,602 $ 35,667 $ (162) $ 35,505 3 %
Year Ended December 31
2021 2020
IT services Organic IT services Organic Organic sales %
$ in millions Sales sales sales Sales sales sales change
Aeronautics Systems $ 11,259 $ - $ 11,259 $ 12,169 $ - $ 12,169 (7) %
Defense Systems 5,776 (106) 5,670 7,543 (1,637) 5,906 (4) %
Mission Systems 10,134 (42) 10,092 10,080 (527) 9,553 6 %
Space Systems 10,608 (16) 10,592 8,744 (182) 8,562 24 %
Intersegment eliminations (2,110) 2 (2,108) (1,737) 17 (1,720)
Total $ 35,667 $ (162) $ 35,505 $ 36,799 $ (2,329) $ 34,470 3 %
2022 sales increased $935 million and 2022 organic sales increased $1.1 billion ,
or 3 percent, due to higher sales at Space Systems and Mission Systems,
partially offset by lower sales at Aeronautics Systems and Defense Systems. 2022
sales reflect strong demand, the timing of material receipts and improving
trends in labor availability during the second half of the year.
See "Segment Operating Results" below for further information by segment and
"Product and Service Analysis" for product and service detail. See Note 16 to
the consolidated financial statements for information regarding the company's
sales by customer type, contract type and geographic region for each of our
segments.
Operating Income and Margin Rate
2022 operating income decreased $2.1 billion , or 36 percent, primarily due to a
$2.0 billion pre-tax gain on sale and $192 million of unallocated corporate
expenses recognized in the prior year associated with the IT services
divestiture. Operating income also decreased due to a $330 million reduction in
the FAS/CAS operating adjustment, which more than offset higher segment
operating income and lower non-divestiture-related unallocated corporate
expense. 2022 operating margin rate declined to 9.8 percent from 15.8 percent
reflecting the items above.
2022 G&A costs as a percentage of sales increased to 10.6 percent from 10.1 percent, primarily due to an increase in investments for future business opportunities.
For further information regarding product and service operating costs and expenses, see "Product and Service Analysis" below.
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Mark-to-Market Pension and OPB Benefit/Expense
The primary components of pre-tax MTM benefit (expense) are presented in the
table below:
Year Ended December 31
$ in millions 2022 2021 2020
Actuarial gains (losses) on projected benefit obligation
Actuarial (losses) gains on plan assets (8,430) 1,192 2,536 MTM benefit (expense)$ 1,232 $ 2,355 $ (1,034) 2022 MTM benefit (expense) of$1.2 billion was primarily driven by a 256 basis point increase in the discount rate from year end 2021, partially offset by losses of 15.4 percent on plan assets compared to our 7.5 percent asset return assumption. Federal and Foreign Income Taxes The 2022 effective tax rate (ETR) decreased to 16.1 percent from 21.6 percent primarily due to an$86 million benefit resulting from the resolution of theIRS examination of certain legacy OATK tax returns, as well as additional federal income taxes in the prior year resulting from the IT services divestiture. The company's 2022 MTM benefit increased the 2022 ETR by 1.2 percentage points; however, the 2021 MTM benefit did not significantly impact the 2021 ETR. See Note 7 to the consolidated financial statements for additional information. Net Earnings The table below reconciles net earnings to transaction-adjusted net earnings: Year Ended December 31 % Change in $ in millions 2022 2021 2020 2022 2021 Net earnings$ 4,896 $ 7,005 $ 3,189 (30) % 120 % MTM (benefit) expense (1,232) (2,355) 1,034 (48) % (328) % MTM-related deferred state tax expense (benefit)(1) 65 124 (54) (48) % (330) % Federal tax expense (benefit) of items above(2) 245 469 (206) (48) % (328) % MTM adjustment, net of tax (922) (1,762) 774 (48) % (328) % Gain on sale of business - (1,980) - NM NM State tax impact(3) - 160 - NM NM Transaction costs - 32 - NM NM Make-whole premium - 54 - NM NM Federal tax impact of items above(4) - 614 - NM NM Transaction adjustment, net of tax - (1,120) - NM NM Transaction-adjusted net earnings$ 3,974 $ 4,123 $ 3,963 (4) % 4 %
(1)The deferred state tax impact in each period was calculated using the company's blended state tax rate of 5.25 percent and is included in Unallocated corporate expense within operating income.
(2)The federal tax impact in each period was calculated by subtracting the deferred state tax impact from MTM benefit (expense) and applying the 21 percent federal statutory rate.
(3)The state tax impact includes
(4)The federal tax impact was calculated by applying the 21 percent federal
statutory rate to the adjustment items and also includes
2022 net earnings decreased$2.1 billion , or 30 percent, principally due to a$1.1 billion decrease associated with the IT services divestiture, net of tax, and an$840 million decrease in our MTM benefit (expense), net of tax. Transaction-adjusted net earnings decreased$149 million , or 4 percent, primarily due to a$330 million reduction in the FAS/CAS operating adjustment and$97 million of lower returns on marketable securities, partially offset by lower income tax and interest expense and higher segment operating income. -35- --------------------------------------------------------------------------------
NORTHROP GRUMMAN CORPORATION Diluted Earnings Per Share The table below reconciles diluted earnings per share to transaction-adjusted EPS: Year Ended December 31 % Change in 2022 2021 2020 2022 2021 Diluted earnings per share$ 31.47 $ 43.54 $ 19.03 (28) % 129 % MTM (benefit) expense per share (7.92) (14.64) 6.17 (46) % (337) %
MTM-related deferred state tax expense (benefit) per share(1)
0.42 0.77 (0.32) (45) % (341) %
Federal tax expense (benefit) of items above per share(2) 1.57
2.92 (1.23) (46) % (337) %
MTM adjustment per share, net of tax (5.93) (10.95) 4.62 (46) % (337) %
Gain on sale of business per share - (12.31) - NM NM
State tax impact(3) per share - 0.99 - NM NM
Transaction costs per share - 0.20 - NM NM
Make-whole premium per share - 0.34 - NM NM
Federal tax impact of items above(4) per share - 3.82 - NM NM
Transaction adjustment per share, net of tax - (6.96) - NM NM
Transaction-adjusted EPS $ 25.54 $ 25.63 $ 23.65 - % 8 %
(1)The deferred state tax impact in each period was calculated using the company's blended state tax rate of 5.25 percent and is included in Unallocated corporate expense within operating income.
(2)The federal tax impact in each period was calculated by subtracting the deferred state tax impact from MTM benefit (expense) and applying the 21 percent federal statutory rate.
(3)The state tax impact includes
(4)The federal tax impact was calculated by applying the 21 percent federal
statutory rate to the adjustment items and also includes
2022 diluted earnings per share decreased$12.07 , or 28 percent, principally due to a$6.96 decrease associated with the IT services divestiture, net of tax, and a$5.02 decrease in our 2022 MTM benefit, net of tax. Transaction-adjusted EPS was comparable with the prior year and reflects a 4 percent reduction in transaction-adjusted net earnings and a 3 percent decrease in weighted-average diluted shares outstanding. SEGMENT OPERATING RESULTS Basis of Presentation The company is aligned in four operating sectors, which also comprise our reportable segments: Aeronautics Systems, Defense Systems, Mission Systems and Space Systems. For a more complete description of each segment's products and services, see "Business."
We present our sectors in the following business areas, which are reported in a manner reflecting core capabilities:
Aeronautics Systems Defense Systems Mission Systems Space Systems
Battle Management & Airborne Multifunction Launch & Strategic
Autonomous Systems Missile Systems Sensors Missiles
Maritime/Land Systems &
Manned Aircraft Mission Readiness Sensors Space
Navigation, Targeting &
Survivability
Networked Information
Solutions
This section discusses segment sales, operating income and operating margin rate. A reconciliation of segment operating income to total operating income is provided below.
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Segment Operating Income and Margin Rate
Segment operating income, as reconciled in the table below, and segment
operating margin rate (segment operating income divided by sales) are non-GAAP
measures that reflect the combined operating income of our four segments less
the operating income associated with intersegment sales. Segment operating
income includes pension expense allocated to our sectors under FAR and CAS and
excludes FAS pension service expense and unallocated corporate items (certain
corporate-level expenses, which are not considered allowable or allocable under
applicable FAR and CAS requirements, and costs not considered part of
management's evaluation of segment operating performance). These non-GAAP
measures may be useful to investors and other users of our financial statements
as supplemental measures in evaluating the financial performance and operational
trends of our sectors. These measures may not be defined and calculated by other
companies in the same manner and should not be considered in isolation or as
alternatives to operating results presented in accordance with GAAP.
Year Ended December 31 % Change in
$ in millions 2022 2021 2020 2022 2021
Operating income $ 3,601 $ 5,651 $ 4,065 (36) % 39 %
Operating margin rate 9.8 % 15.8 % 11.0 %
Reconciliation to segment operating income:
CAS pension expense (167) (544) (827) (69) % (34) %
FAS pension service expense 367 414 409 (11) % 1 %
FAS/CAS operating adjustment 200 (130) (418) (254) % (69) %
Gain on sale of business - (1,980) - NM NM
IT services divestiture - unallowable state
taxes and transaction costs - 192 - NM NM
Intangible asset amortization and PP&E
step-up depreciation 242 254 322 (5) % (21) %
MTM-related deferred state tax expense
(benefit)(1) 65 124 (54) (48) % (330) %
Other unallocated corporate expense 145 106 273 37 % (61) %
Unallocated corporate expense (income) 452 (1,304) 541 (135) % (341) %
Segment operating income $ 4,253 $ 4,217 $ 4,188 1 % 1 %
Segment operating margin rate 11.6 % 11.8 % 11.4 %
(1)Represents the deferred state tax benefit associated with MTM benefit (expense), which is recorded in Unallocated corporate expense consistent with other changes in deferred state taxes.
Segment Operating Income and Margin Rate 2022 segment operating income increased$36 million , or 1 percent, due to higher operating income at Mission Systems, Space Systems and Aeronautics Systems, partially offset by lower operating income at Defense Systems due, in part, to the impact of the IT services divestiture. 2021 segment operating income included$20 million from the IT services business, as well as a benefit of approximately$100 million due to the impact of lower overhead rates on the company's fixed price contracts. Segment operating margin rate decreased to 11.6 percent from 11.8 percent principally due to lower net EAC adjustments due, in part, to macroeconomic impacts, including inflationary pressures and supply chain challenges. FAS/CAS Operating Adjustment The decrease in our 2022 FAS/CAS operating adjustment is due to lower CAS pension expense resulting from favorable plan asset returns in 2021 and changes in certain CAS actuarial assumptions as ofDecember 31, 2021 . Unallocated Corporate Expense (Income) The change in 2022 unallocated corporate expense (income) is primarily due to the prior year$2.0 billion pre-tax gain on sale and$192 million of unallowable state taxes and transaction costs associated with the IT services divestiture. -37- --------------------------------------------------------------------------------
Net Estimate-At-Completion (EAC) Adjustments - We record changes in estimated
contract earnings at completion (net EAC adjustments) using the cumulative
catch-up method of accounting. Net EAC adjustments can have a significant effect
on reported sales and operating income and the aggregate amounts are presented
in the table below:
Year Ended December 31
$ in millions 2022 2021 2020
Favorable EAC adjustments $ 1,337 $ 1,242 $ 1,082
Unfavorable EAC adjustments (977) (715) (616)
Net EAC adjustments $ 360 $ 527 $ 466 Net EAC adjustments by segment are presented in the table below:
Year Ended December 31
$ in millions 2022 2021 2020
Aeronautics Systems $ 174 $ 25 $ 77
Defense Systems 111 113 148
Mission Systems 138 263 216
Space Systems (38) 134 33
Eliminations (25) (8) (8)
Net EAC adjustments $ 360 $ 527 $ 466
For purposes of the discussion in the remainder of this Segment Operating
Results section, references to operating income and operating margin rate
reflect segment operating income and segment operating margin rate,
respectively.
AERONAUTICS SYSTEMS
Year Ended December 31 % Change in
$ in millions 2022 2021 2020 2022 2021
Sales $ 10,531 $ 11,259 $ 12,169 (6) % (7) %
Operating income 1,116 1,093 1,206 2 % (9) %
Operating margin rate 10.6 % 9.7 % 9.9 %
Sales
2022 sales decreased $728 million , or 6 percent, due to lower volume in both
Manned Aircraft and Autonomous Systems, including restricted programs, a $180
million decrease on the Global Hawk program, a $159 million decrease on the E-2
program and a $119 million decrease on the JSTARS program as it nears
completion.
Operating Income
2022 operating income increased $23 million , or 2 percent, due to a higher
operating margin rate, partially offset by lower sales. 2022 operating margin
rate increased to 10.6 percent from 9.7 percent primarily due to higher net
favorable EAC adjustments and a $38 million gain on a property sale. Higher net
favorable EAC adjustments reflect $133 million of positive adjustments on the
engineering, manufacturing and development phase of the B-21 program, partially
offset by lower net EAC adjustments associated with other restricted work, as
well as $135 million of unfavorable EAC adjustments on F-35 in the prior year.
The prior year operating margin rate also reflects a $21 million benefit
associated with favorable overhead rate performance.
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NORTHROP GRUMMAN CORPORATION
DEFENSE SYSTEMS
Year Ended December 31 % Change in
$ in millions 2022 2021 2020 2022 2021
Sales $ 5,579 $ 5,776 $ 7,543 (3) % (23) %
Operating income 664 696 846 (5) % (18) %
Operating margin rate 11.9 % 12.0 % 11.2 %
Sales
2022 sales decreased $197 million , or 3 percent, due, in part, to a $106 million
reduction in sales related to the IT services divestiture. 2022 organic sales
decreased $91 million , or 2 percent, principally due to a $154 million decrease
from lower scope on an international training program, completion of a Joint
Services support program and wind-down of the UKAWACS and JSTARS programs,
partially offset by a $144 million increase from ramp-up on the Integrated Air
and Missile Defense Battle Command System (IBCS) program, as well as higher
volume on the Special Ammunition and Weapon Systems (SAWS) and NATO Alliance
Ground Surveillance In-Service Support (NATO AGS ISS) programs.
Operating Income
2022 operating income decreased $32 million , or 5 percent, due, in part, to a
$14 million reduction in operating income related to the IT services
divestiture, as well as lower sales. Operating margin rate was comparable with
the prior year.
MISSION SYSTEMS
Year Ended December 31 % Change in
$ in millions 2022 2021 2020 2022 2021
Sales $ 10,396 $ 10,134 $ 10,080 3 % 1 %
Operating income 1,618 1,579 1,459 2 % 8 %
Operating margin rate 15.6 % 15.6 % 14.5 %
Sales
2022 sales increased $262 million , or 3 percent, and includes a $42 million
reduction in sales related to the IT services divestiture. 2022 organic sales
increased $304 million , or 3 percent, primarily due to higher restricted sales
in the Networked Information Solutions business area, $107 million of higher
volume on airborne radar programs and a $107 million increase on the Surface
Electronic Warfare Improvement Program (SEWIP). These increases were partially
offset by a $231 million decrease on Navigation, Targeting and Survivability
programs and a $118 million decrease on the Joint Counter Radio-Controlled
Improvised Explosive Device Electronic Warfare (JCREW) program.
Operating Income
2022 operating income increased $39 million , or 2 percent, due to higher sales.
Operating margin rate was comparable with the prior year and reflects a $33
million benefit recognized in connection with a contract-related legal matter,
partially offset by the previously described overhead rate benefit to fixed
price contracts in the prior year.
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NORTHROP GRUMMAN CORPORATION
SPACE SYSTEMS
Year Ended December 31 % Change in
$ in millions 2022 2021 2020 2022 2021
Sales $ 12,275 $ 10,608 $ 8,744 16 % 21 %
Operating income 1,158 1,121 893 3 % 26 %
Operating margin rate 9.4 % 10.6 % 10.2 %
Sales
2022 sales and organic sales increased$1.7 billion , or 16 percent, due to higher sales in both business areas. Launch & Strategic Missiles sales increased primarily due to ramp-up on development programs, including a$454 million increase on the Ground Based Strategic Deterrent (GBSD) program and a$449 million increase on the Next Generation Interceptor (NGI) program, as well as higher volume on the GEM63 program in support of Amazon's Project Kuiper. Sales in the Space business area were driven by a$320 million increase due to ramp-up on theSpace Development Agency (SDA) Tranche 1 Transport and Tracking Layer programs awarded earlier this year, higher volume on restricted programs and a$134 million increase in sales on the Commercial Resupply Services (CRS) program, partially offset by a$149 million decrease in sales for the James Webb Space Telescope after its successful launch inDecember 2021 . Operating Income 2022 operating income increased$37 million , or 3 percent, due to higher sales, partially offset by a lower operating margin rate. Operating margin rate decreased to 9.4 percent from 10.6 percent primarily due to lower net EAC adjustments and a$45 million write-down of commercial inventory, partially offset by a$96 million gain recognized in connection with a land exchange transaction. -40- --------------------------------------------------------------------------------
NORTHROP GRUMMAN CORPORATION PRODUCT AND SERVICE ANALYSIS
The following table presents product and service sales and operating costs and expenses by segment:
Year Ended December 31
$ in millions 2022 2021 2020
Operating Costs Operating Costs Operating Costs
Segment Information: Sales and Expenses Sales and Expenses Sales and Expenses
Aeronautics Systems
Product $ 7,981 $ 7,161 $ 9,408 $ 8,534 $ 10,437 $ 9,435
Service 2,311 2,042 1,662 1,462 1,610 1,417
Intersegment eliminations 239 212 189 170 122 111
Total Aeronautics Systems 10,531 9,415 11,259 10,166 12,169 10,963
Defense Systems
Product 2,717 2,385 2,564 2,243 3,024 2,740
Service 2,056 1,819 2,423 2,137 3,791 3,305
Intersegment eliminations 806 711 789 700 728 652
Total Defense Systems 5,579 4,915 5,776 5,080 7,543 6,697
Mission Systems
Product 7,376 6,291 7,064 6,017 6,744 5,757
Service 2,005 1,639 2,077 1,695 2,557 2,201
Intersegment eliminations 1,015 848 993 843 779 663
Total Mission Systems 10,396 8,778 10,134 8,555 10,080 8,621
Space Systems
Product 10,448 9,455 8,832 7,898 6,810 6,084
Service 1,708 1,557 1,637 1,464 1,826 1,672
Intersegment eliminations 119 105 139 125 108 95
Total Space Systems 12,275 11,117 10,608 9,487 8,744 7,851
Segment Totals
Total Product $ 28,522 $ 25,292 $ 27,868 $ 24,692 $ 27,015 $ 24,016
Total Service 8,080 7,057 7,799 6,758 9,784 8,595
Total Segment(1) $ 36,602 $ 32,349 $ 35,667 $ 31,450 $ 36,799 $ 32,611 (1)A reconciliation of segment operating income to total operating income is included in "Segment Operating Results."
Product Sales and Costs 2022 product sales increased$654 million , or 2 percent, primarily due to an increase in product sales at Space Systems, partially offset by a decrease in product sales at Aeronautics Systems. The increase at Space Systems was driven by ramp-up on development programs including GBSD and NGI, as well as higher volume on the SDA Tranche 1 Transport Layer and Tranche 1 Tracking Layer programs. The decrease at Aeronautics Systems was principally due to lower volume on restricted programs, as well as the Global Hawk and E-2 programs.
2022 product costs increased
Service Sales and Costs 2022 service sales increased$281 million , or 4 percent, primarily due to an increase in service sales at Aeronautics Systems, principally on restricted programs, partially offset by a decrease in service sales at Defense Systems. The decrease at Defense Systems was driven by lower scope on an international training program, the impact of the IT services divestiture, completion of a Joint Services support program and wind-down of the UKAWACS program. Sales from the divested IT services business, which were largely included in service sales, were$162 million in the prior year.
2022 service costs increased
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--------------------------------------------------------------------------------BACKLOG
Backlog represents the future sales we expect to recognize on firm orders received by the company and is equivalent to the company's remaining performance obligations at the end of each period. It comprises both funded backlog (firm orders for which funding is authorized and appropriated) and unfunded backlog. Unexercised contract options and indefinite delivery indefinite quantity (IDIQ) contracts are not included in backlog until the time the option or IDIQ task order is exercised or awarded. Backlog is converted into sales as costs are incurred or deliveries are made.
Backlog consisted of the following at
2022 2021
Total Total
$ in millions Funded Unfunded Backlog Backlog % Change in 2022
Aeronautics Systems $ 8,458 $ 10,939 $ 19,397 $ 18,277 6 %
Defense Systems 5,881 1,634 7,515 6,349 18 %
Mission Systems 9,835 4,040 13,875 14,306 (3) %
Space Systems 8,317 29,639 37,956 37,114 2 %
Total backlog $ 32,491 $ 46,252 $ 78,743 $ 76,046 4 %
2022 net awards totaled $39.3 billion . Significant 2022 new awards include $10.6
billion for restricted programs (principally at Aeronautics Systems, Mission
Systems and Space Systems), $5.3 billion for F-35, $2.1 billion for GEM63 solid
rocket boosters, largely related to Amazon's Project Kuiper, $1.5 billion for
the SDA Tranche 1 Transport and Tracking Layer programs, $1.3 billion for
Commercial Resupply Services (CRS) missions and $1.3 billion for Ground-based
Midcourse Defense (GMD).
LIQUIDITY AND CAPITAL RESOURCES
We are focused on the efficient conversion of operating income into cash to provide for the company's material cash requirements, including working capital needs, satisfaction of contractual commitments, funding of our pension and OPB plans, investment in our business through capital expenditures, and shareholder return through dividend payments and share repurchases. As ofDecember 31, 2022 , we had cash and cash equivalents of$2.6 billion ;$316 million was held outside of theU.S. by foreign subsidiaries. We expect cash and cash equivalents and cash generated from operating activities, supplemented by borrowings under credit facilities, commercial paper and/or in the capital markets through our shelf registration with theSEC , if needed, to be sufficient to provide liquidity to the company in the short-term and long-term. The company has a five-year senior unsecured credit facility in an aggregate principal amount of$2.5 billion , and inApril 2022 , we renewed our one-year$500 million uncommitted credit facility. AtDecember 31, 2022 , there were no borrowings outstanding under these credit facilities. The company's principal contractual commitments include purchase obligations, repayments of long-term debt and related interest, and payments under operating leases. AtDecember 31, 2022 , we had$19.0 billion of purchase obligations, approximately half of which is short-term. Purchase obligations are largely comprised of open purchase order commitments to suppliers and subcontractors underU.S. government contracts. In most circumstances, our risk associated with the purchase obligations on ourU.S. government contracts is limited to the termination liability provisions within those contracts. As such, we do not believe they represent a material liquidity risk to the company. AtDecember 31, 2022 , we had capital expenditure commitments of$1.5 billion , which we expect to satisfy with cash on hand. We also had provisions for uncertain tax positions of$1.7 billion , some or all of which could result in future cash payments to various taxing authorities. At this time, we are unable to estimate the timing and amount of any future cash outflows related to these uncertain tax positions. Refer to the respective notes to the consolidated financial statements for further information about our share repurchase programs (Note 3), commercial paper, credit facilities and long-term debt (Note 10), standby letters of credit and guarantees (Note 12), future minimum contributions for the company's pension and OPB plans (Note 13), and lease payment obligations (Note 15). COVID-19 and the CARES Act The Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act") established a program with provisions to allowU.S. companies to defer the employer's portion of social security taxes betweenMarch 27, 2020 andDecember 31, 2020 and pay such taxes in two installments in 2021 and 2022. Our first installment of deferred social security taxes of$200 million was paid in the fourth quarter of 2021 and the second installment of$200 million was -42- --------------------------------------------------------------------------------
paid in the fourth quarter of 2022. Under Section 3610, the CARES Act also authorized the government to reimburse qualifying contractors for certain costs of providing paid leave to employees as a result of COVID-19. The company has sought and may continue to seek recovery for certain COVID-19-related costs under Section 3610 of the CARES Act and through our contract provisions, though it is unclear what funds will be available and how much we will be able to recover. In addition, theDoD has taken steps to increase the rate for certain progress payments from 80 percent to 90 percent for costs incurred and work performed on relevant contracts; it is unclear how long the 90 percent progress payment rate will remain in place and whether theDoD will take any further steps. Internal Revenue Code (IRC) Section 174 Beginning in 2022, the Tax Cuts and Jobs Act of 2017 ("TCJA") eliminated the option to deduct research and development expenditures in the current year and requires taxpayers to amortize them over five years pursuant to IRC Section 174. Our 2022 cash from operations were reduced by approximately$900 million for federal tax payments we made related to Section 174. In the future,Congress may consider legislation that would defer the amortization requirement to later years, possibly with retroactive effect. In the meantime, we expect to continue to make additional federal tax payments based on the current Section 174 tax law. The impact of Section 174 on our cash from operations depends on the amount of research and development expenditures incurred by the company and whether theIRS issues guidance on the provision which differs from our current interpretation, among other things. Cash Flow Measures In addition to our cash position, we consider various cash flow measures in capital deployment decision-making, including cash provided by operating activities and adjusted free cash flow, a non-GAAP measure described in more detail below. Operating Cash Flow The table below summarizes key components of cash flow provided by operating activities: Year Ended December 31 $ in millions 2022 2021 2020 Net earnings$ 4,896 $ 7,005 $ 3,189 Gain on sale of business - (1,980) - Non-cash items(1) (1,305) (1,510) 1,799 Pension and OPB contributions (136) (141)
(887)
Changes in trade working capital (600) 181
227
Other, net 46 12
(23)
Net cash provided by operating activities
(1)Includes depreciation and amortization, non-cash lease expense, MTM benefit (expense), stock based compensation expense, deferred income taxes and net periodic pension and OPB income.
2022 cash provided by operating activities decreased
Adjusted Free Cash Flow
Adjusted free cash flow, as reconciled in the table below, is a non-GAAP measure
defined as net cash provided by or used in operating activities, less capital
expenditures, plus proceeds from the sale of equipment to a customer (not
otherwise included in net cash provided by or used in operating activities) and
the after-tax impact of discretionary pension contributions. Adjusted free cash
flow includes proceeds from the sale of equipment to a customer as such proceeds
were generated in a customer sales transaction. It also includes the after-tax
impact of discretionary pension contributions for consistency and comparability
of financial performance. This measure may not be defined and calculated by
other companies in the same manner. We use adjusted free cash flow as a key
factor in our planning for, and consideration of, acquisitions, the payment of
dividends and stock repurchases. This non-GAAP measure may be useful to
investors and other users of our financial statements as a supplemental measure
of our cash performance, but should not be considered in isolation, as a measure
of residual cash flow available for discretionary purposes, or as an alternative
to operating cash flows presented in accordance with GAAP.
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The table below reconciles net cash provided by operating activities to adjusted
free cash flow:
Year Ended December 31 % Change in
$ in millions 2022 2021 2020 2022 2021
Net cash provided by operating activities $ 2,901 $ 3,567 $ 4,305 (19) % (17) %
Capital expenditures (1,435) (1,415) (1,420) 1 % - %
Proceeds from sale of equipment to a customer 155 84 205 85 % (59) %
After-tax discretionary pension contributions - - 593 NM (100) %
Adjusted free cash flow $ 1,621 $ 2,236 $ 3,683 (28) % (39) %
2022 adjusted free cash flow decreased
Investing Cash Flow
2022 net cash used in investing activities was$1.2 billion compared to net cash provided by investing activities of$2.1 billion in the prior year, principally due to$3.4 billion in cash received from the sale of our IT services business during the first quarter of 2021.
Financing Cash Flow
2022 net cash used in financing activities decreased$4.4 billion principally due to a$2.2 billion decrease in debt repayments and a$2.2 billion reduction in share repurchases.
CRITICAL ACCOUNTING POLICIES, ESTIMATES AND JUDGMENTS
Our consolidated financial statements are prepared in conformity with GAAP,
which requires us to make estimates and assumptions about future events that
affect the amounts reported in our consolidated financial statements. We employ
judgment in making our estimates in consideration of historical experience,
currently available information and various other assumptions that we believe to
be reasonable under the circumstances. Actual results could differ from our
estimates and assumptions, and any such differences could be material to our
consolidated financial statements. We believe the following accounting policies
are critical to the understanding of our consolidated financial statements and
require the use of significant management judgment in their application. For a
summary of our significant accounting policies, see Note 1 to the consolidated
financial statements.
Revenue Recognition
Due to the long-term nature of our contracts, we generally recognize revenue
over time using the cost-to-cost method, which requires us to make reasonably
dependable estimates regarding the revenue and cost associated with the design,
manufacture and delivery of our products and services.
Contract sales may include estimates of variable consideration, including cost
or performance incentives (such as award and incentive fees), contract claims
and requests for equitable adjustment (REAs). Variable consideration is included
in total estimated sales to the extent it is probable that a significant
reversal in the amount of cumulative revenue recognized will not occur when the
uncertainty associated with the variable consideration is subsequently resolved.
We estimate variable consideration as the most likely amount to which we expect
to be entitled.
Our cost estimation process is based on the professional knowledge of our
engineering, program management and financial professionals, and draws on their
significant experience and judgment. We prepare EACs for our contracts and
calculate an estimated contract profit based on total estimated contract sales
and cost. Since our contracts typically span a period of several years,
estimation of revenue, cost, and progress toward completion requires the use of
judgment. Factors considered in these estimates include our historical
performance, the availability, productivity and cost of labor, the nature and
complexity of work to be performed, the effect of change orders, availability
and cost of materials, components and subcontracts, the effect of any delays in
performance and the level of indirect cost allocations.
We also consider the impact of macroeconomic factors on our estimates, in
particular on contract EACs that span several years. For example, during 2022,
we included in our EACs management's best estimate of the impact inflation has
had and may continue to have on our contracts. We also included our current best
estimate of the impact on our EACs of disruptions we have experienced and
continue to experience in the supply chain. The volatility of the recent
macroeconomic environment has added complexity to our estimation process and may
result in our year end 2022 contract EACs having more variability in the future
than they might otherwise have had if the estimates had been prepared in a more
stable macroeconomic environment.
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--------------------------------------------------------------------------------We generally review and reassess our sales, cost and profit estimates for each significant contract at least annually or more frequently as determined by the occurrence of events, changes in circumstances and evaluations of contract performance to reflect the latest reliable information available. The company performs on a broad portfolio of long-term contracts, including the development of complex and customized military platforms and systems, as well as advanced electronic equipment and software, that often include technology at the forefront of science. Cost estimates on fixed-price development contracts and early-stage/low-rate production contracts are inherently more uncertain as to future events than on mature, full-rate production contracts. As a result, there is typically more variability in those estimates and greater financial risk associated with unanticipated cost growth on fixed-price development contracts and early-stage/low-rate production contracts. Changes in estimates occur for a variety of reasons, including changes in contract scope, the resolution of risk at lower or higher cost than anticipated, unanticipated performance and other risks affecting contract costs, performance issues with subcontractors or suppliers, changes in indirect cost allocations, such as overhead and G&A costs, and changes in estimated award and incentive fees. Identified risks typically include technical, schedule and/or performance risk based on our evaluation of the contract effort. Similarly, the changes in estimates may include changes in, or resolution of, identified opportunities for operating margin improvement.
For the impacts of changes in estimates on our consolidated statements of earnings and comprehensive income, see "Segment Operating Results" and Note 1 to the consolidated financial statements.
Retirement Benefits Overview - The determination of projected benefit obligations, the fair value of plan assets, and pension and OPB expense for our retirement benefit plans requires the use of estimates and actuarial assumptions. We perform an annual review of our actuarial assumptions in consultation with our actuaries. As we determine changes in the assumptions are warranted, or as a result of plan amendments, future pension and OPB expense and our projected benefit obligation could increase or decrease. The principal estimates and assumptions that have a significant effect on our consolidated financial position and annual results of operations are the discount rate, cash balance crediting rate, expected long-term rate of return on plan assets, estimated fair market value of plan assets, and the mortality rate of those covered by our pension and OPB plans. The effects of actual results differing from our assumptions and the effects of changing assumptions (i.e., actuarial gains or losses) are recognized immediately through earnings upon annual remeasurement in the fourth quarter, or on an interim basis as triggering events warrant remeasurement. Discount Rate - The discount rate represents the interest rate used to determine the present value of future cash flows currently expected to be required to settle our pension and OPB obligations. The discount rate is generally based on the yield of high-quality corporate fixed-income investments. At the end of each year, we determine the discount rate using a theoretical bond portfolio model of bonds rated AA or better to match the notional cash outflows related to projected benefit payments for each of our significant benefit plans. Taking into consideration the factors noted above, our weighted-average composite pension discount rate was 5.54 percent atDecember 31, 2022 and 2.98 percent atDecember 31, 2021 . The effects of a hypothetical change in the discount rate may be nonlinear and asymmetrical for future years as the discount rate changes. Holding all other assumptions constant, an increase or decrease of 25 basis points in theDecember 31, 2022 discount rate assumption would have the following estimated effects on 2022 pension and OPB obligations, which would be reflected in the 2022 MTM expense (benefit), and 2023 expected pension and OPB expense: 25 Basis Point 25 Basis Point $ in millions Decrease in Rate Increase in Rate 2022 pension and OPB obligation and MTM expense (benefit) $ 817 $ (781) 2023 pension and OPB (benefit) expense (20) 18 -45- --------------------------------------------------------------------------------
Cash Balance Crediting Rate - A portion of the company's pension obligation and resulting pension expense is based on a cash balance formula, where participants' hypothetical account balances are accumulated over time with pay-based credits and interest. Interest is credited monthly using the current 30-Year Treasury bond rate. The interest crediting rate is part of the cash balance formula and independent of actual pension investment earnings. The cash balance crediting rate used for FAS purposes tends to move in concert with the discount rate but has an offsetting effect on pension benefit obligations and the related MTM expense (benefit). The minimum cash balance crediting rate allowed under the plan is 2.25 percent. The cash balance crediting rate assumption has been set to its current level of 3.96 percent as ofDecember 31, 2022 , declining to 3.88 percent by 2028. Holding all other assumptions constant, an increase or decrease of 25 basis points in theDecember 31, 2022 cash balance crediting rate assumption would have the following estimated effects on the 2022 pension benefit obligation, which would be reflected in the 2022 MTM expense (benefit), and 2023 expected pension expense: 25 Basis Point 25 Basis Point $ in millions Decrease in Rate Increase in Rate 2022 pension obligation and MTM expense (benefit) $ (96) $ 100 2023 pension (benefit) expense (9) 9 Expected Long-Term Rate of Return on Plan Assets - The expected long-term rate of return on plan assets (EROA) assumption reflects the average rate of net earnings we expect on current and future benefit plan investments. EROA is a long-term assumption, which we review annually and adjust to reflect changes in our long-term view of expected market returns and/or significant changes in our plan asset investment policy. Due to the inherent uncertainty of this assumption, we consider multiple data points at the measurement date including the plan's target asset allocation, historical asset returns and third party projection models of expected long-term returns for each of the plans' strategic asset classes. In addition to the data points themselves, we consider trends in the data points, including changes from the prior measurement date. The EROA assumptions we use for pension benefits are consistent with those used for OPB plans; however, we reduce the EROA for OPB plans to allow for the impact of tax on investment earnings, as certainVoluntary Employee Beneficiary Association trusts are taxable. During 2022, the Investment Committee of the company's benefit plans reviewed the plans' major asset class allocations and approved an update to increase the target fixed-income asset allocation from 30% to 40%. The current asset allocation is now approximately 35% fixed-income, 30% public equities, 30% alternatives and 5% cash. At this time, the Investment Committee is not planning any significant changes to that mix. For further information on plan asset investments, see Note 13 to the consolidated financial statements. While historical market returns are not necessarily predictive of future market returns, given our long history of plan performance supported by the stability in our investment mix, investment managers, and active asset management, we believe our actual historical performance is a reasonable metric to consider when developing our EROA. Our average annual rate of return from 1976 to 2022 was approximately 10.7 percent and our 20-year and 30-year rolling average rates of return were approximately 8.6 percent and 8.8 percent, respectively, each determined on an arithmetic basis and net of expenses. Our 2022 losses on plan assets, net of expenses, were approximately 15.4 percent. Consistent with our past practice, we obtained long-term capital market forecasting models from several third parties and, using our target asset allocation, developed an expected rate of return on plan assets from each model. We considered not only the specific returns projected by those third party models, but also changes in the models year-to-year when developing our EROA. Despite the change in our target asset allocation described above, these models show a year-over-year increase in the expected rate of return on plan assets largely due to recent increases in interest rates, which more than offset the downward pressure on our EROA caused by the change in asset mix. For determining 2022 FAS expense, we assumed an expected long-term rate of return on pension plan assets of 7.5 percent and an expected long-term rate of return on OPB plan assets of 7.19 percent. For 2023 FAS expense, we have assumed an expected long-term rate of return on pension plan assets of 7.5 percent and 7.23 percent on OPB plans. Holding all other assumptions constant, an increase or decrease of 25 basis points in ourDecember 31, 2022 EROA assumption would have the following estimated effects on 2023 expected pension and OPB expense: 25 Basis Point 25 Basis Point $ in millions Decrease Increase 2023 pension and OPB expense (benefit) $ 73 $ (73) -46- --------------------------------------------------------------------------------
NORTHROP GRUMMAN CORPORATION In addition, holding all other assumptions constant, an increase or decrease of 100 basis points in actual versus expected return on plan assets would have the following estimated effects on our 2023 MTM expense (benefit): $ in millions 100 Basis Point Decrease 100 Basis Point Increase 2023 MTM expense (benefit) $ 292 $ (292) Estimated Fair Market Value of Plan Assets - For certain plan assets where the fair market value is not readily determinable, such as real estate, private equity, hedge funds and opportunistic investments, we develop estimates of fair value using the best information available. Estimated fair values on these plan assets are based on redemption values and net asset values (NAV), as well as valuation methodologies that include third party appraisals, comparable transactions, discounted cash flow valuation models and public market data. Mortality Rate - Mortality assumptions are used to estimate life expectancies of plan participants. InOctober 2014 , theSociety of Actuaries Retirement Plans Experience Committee (RPEC) issued updated mortality tables and a mortality improvement scale, which reflected longer life expectancies than previously projected. InOctober 2019 , the RPEC issued an updated mortality base table (the Private Retirement Plans Mortality table for 2012 (Pri-2012)), which we adopted after reviewing our own historical mortality experience. InOctober 2021 , the RPEC released a new projection scale (MP-2021) that included additional underlying data for 2019, which included an increase in life expectancies relative to the prior year. The RPEC did not release a MP-2022 projection scale citing complexities in incorporating the substantial number of "excess deaths" in 2020 into their existing model and uncertainties about future expectations primarily related to COVID-19. As such, after considering the information released by the RPEC inOctober 2021 as well as the company's recent mortality experience in light of the COVID-19 pandemic, we adopted the full MP-2021 projection scale while continuing to use the Pri-2012 White Collar table. While the amounts and structure of the PRI-2012 base mortality table with the MP-2021 projection scale continues to reflect a reasonable estimate of mortality, we supplemented the table with 50% of the Gradual Wear-Off illustration as outlined in the RPEC's 2022 Mortality Improvement Update paper to reflect the future impacts of COVID-19. Accordingly, we updated the mortality assumptions used in calculating our pension and OPB obligations recognized atDecember 31, 2022 , and the amounts estimated for our 2023 pension and OPB expense.
For further information regarding our pension and OPB plans, see "Risk Factors" and Notes 1 and 13 to the consolidated financial statements.
Litigation, Commitments and Contingencies We are subject to a range of claims, disputes, enforcement actions, investigations, lawsuits, overhead cost claims, environmental matters, income tax matters and administrative proceedings that arise in the ordinary course of business. Estimating liabilities and costs associated with these matters requires judgment based upon the professional knowledge and experience of management. We determine whether to record a reserve and, if so, what amount based on consideration of the facts and circumstances of each matter as then known to us. Determinations regarding whether to record a reserve and, if so, of what amount, reflect management's assessment regarding what is likely to occur; they do not necessarily reflect what management believes should occur. The ultimate resolution of any such exposure to us may vary materially from earlier estimates as further facts and circumstances develop or become known to us. Environmental Matters - We are subject to environmental laws and regulations in the jurisdictions in which we do or have done business. Factors that could result in changes to the assessment of probability, range of reasonably estimated costs and environmental accruals include: modification of planned remedial actions; changes in the estimated time required to conduct remedial actions; discovery of more or less extensive (or different) contamination than anticipated; information regarding the potential causes and effects of contamination; results of efforts to involve other responsible parties; financial capabilities of other responsible parties; changes in laws and regulations, their interpretation or application; contractual obligations affecting remediation or responsibilities; and improvements in remediation technology. As we expect to be able to recover a portion of environmental remediation liabilities through overhead charges on government contracts, such amounts are deferred in prepaid expenses and other current assets (current portion) and other non-current assets until charged to contracts. We use judgment to evaluate the recoverability of our environmental remediation costs, assessing, among other things,U.S. government regulations, ourU.S. government contract mix and past practices. Portions of the company's environmental liabilities we do not expect to be recoverable have been expensed. -47- --------------------------------------------------------------------------------
Income Tax Matters - The evaluation of tax positions taken in a filed tax return, or planned to be taken in a future tax return or claim, requires the use of judgment. We establish reserves for uncertain tax positions when, despite the belief that our tax positions are supportable, there remains uncertainty in a tax position taken in our filed tax returns or planned to be taken in a future tax return or claim. The company follows a recognition and measurement approach, considering the facts, circumstances, and information available at the reporting date. We exercise judgment in determining the level of evidence necessary and appropriate to support our assessment using all available information. The technical merits of a given tax position are derived from sources of authority in the tax law and their applicability to the facts and circumstances of the position. In measuring the tax position, the company considers the amounts and probabilities of the outcomes that could be realized upon settlement. When it is more likely than not that a tax position will be sustained, we record the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority. To the extent we prevail in matters for which reserves have been established or are required to pay amounts in excess of reserves, there could be a significant impact on our consolidated financial position and annual results of operations. For further information on litigation, commitments and contingencies, see "Risk Factors" and Note 1, Note 7, Note 11 and Note 12 to the consolidated financial statements.Goodwill and Long-Lived Assets Overview - We allocate the purchase price of acquired businesses to the underlying tangible and intangible assets acquired and liabilities assumed based upon their respective fair values, with the excess recorded as goodwill. Such fair 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 the fair value of purchased assets and liabilities after the initial measurement period are recognized in net earnings. We recognize purchased intangible assets in connection with our business acquisitions at fair value on the acquisition date. The most significant purchased intangible assets recognized from our acquisitions are generally customer-related intangible assets, including customer contracts and commercial customer relationships. We determine the fair value of those customer-related intangible assets based on estimates and judgments, including the amount and timing of expected future cash flows, long-term growth rates and discount rates. In some cases, we use discounted cash flow analyses, which are based on estimates of future sales, earnings and cash flows after considering such factors as general market conditions, customer budgets, existing firm and future orders, changes in working capital, long term business plans and recent operating performance. We record property, plant and equipment (PP&E) for capital assets used in operating our business. Depreciation expense associated with our PP&E is generally an allowable and allocable cost in accordance with applicable FAR and CAS requirements. However, depreciation expense associated with PP&E used in our commercial businesses, as well as the additional depreciation expense related to the step-up in fair value of PP&E acquired through business combinations, is not allocable to government contracts and is therefore subject to greater recoverability risk than the PP&E for which depreciation expense is recovered through ourU.S. government contracts. Impairment Testing - We test for impairment of goodwill annually at each of our reporting units, which comprise our operating segments. The results of our annual goodwill impairment tests as ofDecember 31, 2022 and 2021, respectively, indicated that the estimated fair value of each reporting unit significantly exceeded its respective carrying value. There were no impairment charges recorded in the years endedDecember 31, 2022 , 2021 and 2020. In addition to performing an annual goodwill impairment test, we may perform an interim impairment test if events occur or circumstances change that suggest goodwill in any of our reporting units may be impaired. Such indicators may include, but are not limited to, the loss of significant business, significant reductions in federal government appropriations or other significant adverse changes in industry or market conditions. During 2022, we determined there were no impairment indicators requiring us to perform an interim goodwill impairment test. When testing goodwill for impairment, we compare the fair values of each of our reporting units to their respective carrying values. To determine the fair value of our reporting units, we primarily use the income approach based on the cash flows we expect the reporting units to generate in the future, consistent with our operating plans. This income valuation method requires management to project sales, operating expenses, working capital, capital spending and cash flows for the reporting units over a multi-year period, as well as to determine the weighted-average cost of capital (WACC) used as a discount rate and terminal value assumptions. The WACC takes into account the relative weights of each component of our 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 assumptions are applied to the final year of the discounted cash flow model. We use industry multiples (including relevant control premiums) of operating earnings to -48- --------------------------------------------------------------------------------
corroborate the fair values of our reporting units determined under the market valuation method of the income approach.
We test for impairment of our long-lived assets, including PP&E and purchased intangible assets, when events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Our assessment is based on our projection of the undiscounted future operating cash flows of the related asset group. If such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amount, we recognize a non-cash impairment charge to reduce the carrying amount to fair value. There were no impairment charges recorded in the years endedDecember 31, 2022 , 2021 and 2020. Impairment assessment inherently involves management judgments as to assumptions about expected future cash flows and the impact of market conditions on those assumptions. Due to the many variables inherent in the estimation of a business' fair value and the relative size of our recorded goodwill and other purchased intangible assets, differences in assumptions may have a material effect on the results of our impairment analysis. -49- --------------------------------------------------------------------------------
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