OVERVIEW

The following discussion should be read along with the unaudited condensed consolidated financial statements included in this Form 10-Q, as well as the company's 2007 Annual Report on Form 10-K, updated by Form 8-K dated July 29, 2008 (2007 Form 10-K), filed with the Securities and Exchange Commission, which provides a more thorough discussion of the company's products and services, industry outlook, and business trends. See discussion of consolidated operating results starting on page I-26 and discussion of segment operating results starting on page I-29.

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

Business Outlook and Operational Trends - The United States and global economies are currently undergoing a period of economic uncertainty, and the related financial markets are experiencing unprecedented volatility. If the future economic environment continues to be less favorable than it has been in recent years, the company could experience difficulties due to the financial viability of certain of its subcontractors and key suppliers. In addition, the volatility in the financial markets will affect the valuation of the company's pension assets and liabilities, resulting in potentially higher pension costs in future periods. Volatility in the company's stock price and declines in its market capitalization could put pressure on the carrying value of its goodwill and other long-lived assets if these conditions persist for an extended period of time. The company's business is conducted primarily with U.S. Government customers under long-term contracts and there have been no material changes to the company's product and service offerings due to the current economic conditions. The U.S. Government's budgetary processes give the company visibility regarding future spending and the threat areas that they are addressing. Management believes that the company's current contracts, and its strong backlog of previously awarded contracts are well aligned with the direction of its customer's future needs, and this provides the company with good insight regarding future cash flows from its businesses. Nonetheless, management recognizes that no business is completely immune to the current economic situation and these economic conditions could adversely affect future defense spending levels which could lead to lower than expected revenues for the company in future years. In conducting its review of the carrying value of the company's long-lived assets in the fourth quarter, management intends to focus on the future cash flows of its businesses as well as the pressures on the company's market capitalization in its evaluation of the carrying value of the company's long-lived assets, including goodwill.

Recent Developments in U.S. Cost Accounting Standards (CAS) Pension Recovery Rules - On September 2, 2008, the CAS Board published an Advance Notice of Proposed Rulemaking that if adopted would provide a framework to partially harmonize the CAS and Employee Retirement Income Security Act (ERISA) rules as revised by the Pension Protection Act of 2006 (PPA). The proposed CAS rule would incorporate provisions for a transition period from the existing CAS to a partially harmonized CAS. After the PPA effective date for "eligible government contractors" (including Northrop Grumman), which were granted a delay in their PPA effective date, the proposed rule would partially mitigate the near term mismatch between CAS costs under government contracts and PPA amended ERISA funding requirements. However, government contractors maintaining defined benefit pension plans in general would still experience a timing mismatch between PPA required pension trust contributions and the CAS pension costs resulting in a deferred CAS recoverable asset. Public comments on the proposed rules are due by November 3, 2008. The CAS Board is required to issue a final rule no later than January 1, 2010. Contractors will be entitled to an equitable adjustment to prices of previously negotiated

NORTHROP GRUMMAN CORPORATION

contracts subject to CAS for increased contract costs which result from mandatory changes required by the final rule.

Notable Events - Notable events or activities during the three months ended September 30, 2008, affecting the company's consolidated financial results included the following:

† Follow-on contract award of $5.1 billion by U.S. Navy for detail design and construction of the Gerald R. Ford (CVN 78) nuclear-powered aircraft carrier. This new class of carrier is the replacement for the Nimitz-class design that originated in the 1960s - see page I-37.

† Signed definitive agreement to purchase 3001 International, Inc. - see Note 5 to the condensed consolidated financial statements in Part I, Item 1.

Other notable events or activities during the nine months ended September 30, 2008, included the following:

† Contract award of $1.5 billion by U.S. Air Force to replace its aerial refueling tanker fleet. Decision by Government Accountability Office (GAO) to uphold protest of aerial refueling tanker award. On September 10, 2008, the Secretary of Defense announced that the competition was cancelled pending the determination for a new competitive proposal and evaluation process - see page I-37.

† Contract award of $1.2 billion by U.S. Navy for a Broad Area Maritime Surveillance Unmanned Aircraft System. The GAO protest filed by the competitor was denied in August 2008 - see page I-37.

† Pre-tax charge of $326 million associated with the LHD-8 and other ships - see page I-37 and Note 6 to the condensed consolidated financial statements in Part I, Item 1.

† Conversion and redemption of 3.5 million shares of mandatorily redeemable convertible preferred stock to 6.4 million shares of common stock - see Note 4 to the condensed consolidated financial statements in Part I, Item 1.

† Sale of Electro-Optical Systems - see Note 5 to the condensed consolidated financial statements in Part I, Item 1.

CRITICAL ACCOUNTING POLICIES, ESTIMATES, AND JUDGMENTS

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

NORTHROP GRUMMAN CORPORATION

CONSOLIDATED OPERATING RESULTS

Selected financial highlights are presented in the table below.


                                                            Three Months Ended              Nine Months Ended
                                                               September 30                    September 30
$ in millions, except per share                             2008            2007           2008             2007
Sales and service revenues                               $  8,381         $ 7,871       $ 24,733         $ 23,063
Cost of sales and service revenues                          7,610           7,065         22,692           20,804
Operating income                                              771             806          2,041            2,259
Interest expense                                              (74 )           (84 )         (223 )           (256 )
Federal and foreign income taxes                              233             240            635              645
Diluted earnings per share from continuing operations        1.50            1.41           3.65             3.86
Net cash provided by operating activities                   1,373           1,015          2,174            2,156

Sales and Service Revenues
Sales and service revenues consist of the following:


                                        Three Months Ended         Nine Months Ended
                                           September 30              September 30
        $ in millions                    2008         2007         2008         2007
        Product sales                 $  4,808      $ 4,264     $ 14,051     $ 12,910
        Service revenues                 3,573        3,607       10,682       10,153

        Sales and service revenues    $  8,381      $ 7,871     $ 24,733     $ 23,063

Sales and service revenues for the three months ended September 30, 2008, increased $510 million as compared with the same period in 2007, reflecting higher sales in all operating segments except Information Technology and Shipbuilding. Sales and service revenues for the three-month period were impacted by lower revenues on the New York City Wireless Network (NYCWiN) program and lower revenues due to lost production and additional costs resulting from the shut-down of the Gulf Coast shipyards caused by Hurricane Gustav.

Sales and service revenues for the nine months ended September 30, 2008, increased $1.7 billion as compared with the same period in 2007, reflecting higher sales in all operating segments. Sales and service revenues for the 2008 period include lower revenues on NYCWiN and the impact of Hurricane Gustav described above and the delays caused by the issues affecting the LHD-8 program disclosed in the first quarter of 2008. See the Segment Operating Results section below for further information.

Cost of Sales and Service Revenues
Cost of sales and service revenues is comprised of the following:

                                              Three Months Ended         Nine Months Ended
                                                 September 30              September 30
   $ in millions                               2008         2007         2008         2007
   Cost of product sales                    $  3,682      $ 3,198     $ 11,204     $  9,894
   % of product sales                          76.6%        75.0%        79.7%        76.6%
   Cost of service revenues                    3,143        3,084        9,168        8,612
   % of service revenues                       88.0%        85.5%        85.8%        84.8%
   General and administrative expenses           785          783        2,320        2,298
   % of total sales and service revenues        9.4%         9.9%         9.4%        10.0%

   Cost of sales and service revenues       $  7,610      $ 7,065     $ 22,692     $ 20,804

NORTHROP GRUMMAN CORPORATION

Cost of Product Sales and Service Revenues - The increase in cost of product sales as a percentage of product sales for the three and nine months ended September 30, 2008, as compared to the same periods in 2007, is primarily due to cost growth at the Gulf Coast shipyards, partially offset by royalty income from patent infringement settlements recorded in the third quarter of 2008. In the first quarter of 2008, the company recorded a $326 million pre-tax charge on LHD-8 and other programs, and in the third quarter of 2008, the company recorded additional costs for work delays at a subcontractor on the LPD program as a result of Hurricane Ike.

The increase in cost of service revenues as a percentage of service revenues for the three months ended September 30, 2008, as compared to the same period in 2007, was primarily due to a negative performance adjustment on the NYCWiN contract in Information Technology. The increase in cost of service revenues as a percentage of service revenues for the nine months ended September 30, 2008, as compared to the same period in 2007, was primarily due to lower performance in the Commercial, State & Local (CS&L) business area in Information Technology.

General and Administrative Expenses - In accordance with industry practice and the regulations that govern the cost accounting requirements for government contracts, most general corporate expenses incurred at both the segment and corporate locations are considered allowable and allocable costs on government contracts. Such costs, for most components of the company, are allocated to contracts in progress on a systematic basis, and contract performance factors include this cost component as an element of cost. General and administrative expenses primarily relate to segment operations. The decrease in general and administrative expenses as a percentage of total sales and service revenues for the three and nine months ended September 30, 2008, is primarily the result of controlling costs while revenues increased over the same comparable period in 2007.

Operating Income
The company considers operating income to be an important measure for evaluating its operating performance and defines "operating income" as revenues less the related cost of producing the revenues and general and administrative expenses. Operating income for the company is further evaluated for each of the business segments in which the company operates, and "segment operating income" is one of the key metrics used by management of the company to internally manage its operations.

The table below reconciles segment operating income to total operating income:

                                       Three Months Ended          Nine Months Ended
                                          September 30               September 30
        $ in millions                  2008           2007         2008         2007
        Segment operating income     $   768        $   816      $  2,010     $ 2,306
        Unallocated expenses             (20 )          (34 )         (95 )      (130 )
        Net pension adjustment            64             31           192          92
        Royalty income adjustment        (41 )           (7 )         (66 )        (9 )

        Total operating income       $   771        $   806      $  2,041     $ 2,259

Segment Operating Income - Segment operating income for the three months ended September 30, 2008, decreased $48 million, or 6 percent, as compared to the same period in 2007. Total segment operating income was 9.2 percent and 10.4 percent of total sales and service revenues for the three months ended September 30, 2008, and 2007, respectively. The decrease in operating income for the three months ended September 30, 2008 was primarily driven by lower operating income in Shipbuilding than in the prior period and by a 2008 negative performance adjustment on the NYCWiN program of $57 million, partially offset by increased patent infringement settlements in the third quarter of 2008. Shipbuilding operating income for the three months ended September 30, 2007 includes $45 million of favorable adjustments for risk reduction on certain contracts at the Gulf Coast shipyards, and $22 million for a pre-tax gain on the AMSEC reorganization.

Segment operating income for the nine months ended September 30, 2008, decreased $296 million, or 13 percent, as compared to the same period in 2007. Total segment operating income was 8.1 percent and

NORTHROP GRUMMAN CORPORATION

10 percent of total sales and service revenues for the nine months ended September 30, 2008, and 2007, respectively. The decrease in operating income is primarily due to the $326 million pre-tax charge recorded in the first quarter of 2008 on LHD-8 and other Shipbuilding programs, and a $57 million performance adjustment on the NYCWiN program, partially offset by the higher sales volume described above and increased patent infringement settlements in the 2008 period. Segment operating income for the nine months ended September 30, 2007 included a $62 million recovery of lost profits due to Hurricane Katrina, $45 million of favorable adjustments for risk reduction on certain contracts at the Gulf Coast shipyards, $22 million for a pre-tax gain on the AMSEC reorganization, and a $55 million negative contract earnings rate adjustment on LHD-8 resulting from manpower constraints following the strike at the Pascagoula shipyard in 2007. See the Segment Operating Results section below and Note 6 to the condensed consolidated financial statements in Part I, Item 1 for further information.

Unallocated Expenses - Unallocated expenses include the portion of corporate expenses not considered allowable or allocable under applicable CAS regulations and the Federal Acquisition Regulation, and therefore not allocated to the segments, such as management and administration, legal, environmental, certain compensation and retiree benefits, and other expenses. Unallocated expenses for the three months ended September 30, 2008, decreased $14 million, or 41 percent, as compared to the same period in 2007, primarily due to $14 million in higher legal and investigative provisions recorded in the third quarter of 2007 over the 2008 period. Unallocated expenses for the nine months ended September 30, 2008, decreased $35 million, or 27 percent, as compared to the same period in 2007, primarily due to $64 million in higher legal and investigative provisions recorded during the 2007 period compared to the 2008 period and lower other corporate unallocated costs in the 2008 period.

Net Pension Adjustment - Net pension adjustment reflects the difference between pension expense determined in accordance with U.S. GAAP and pension expense allocated to the operating segments determined in accordance with CAS. For the three months ended September 30, 2008, and 2007, pension expense determined in accordance with U.S. GAAP was $57 million and $89 million, respectively, and pension expense determined in accordance with CAS amounted to $121 million and $120 million in each period, respectively. For the nine months ended September 30, 2008, and 2007, pension expense determined in accordance with U.S. GAAP was $170 million and $263 million, respectively, and pension expense determined in accordance with CAS amounted to $362 million and $355 million, respectively. The reduction in U.S. GAAP pension expense in 2008 is primarily the result of better than estimated investment returns in 2007, a higher discount rate assumption and pension plan design changes that took effect in 2008.

Royalty Income Adjustment - Royalty income is included in segment operating income and reclassified to other income for financial reporting purposes. See discussion of Other, net below for explanation of year over year variances.

Interest Expense
Interest expense for the three and nine months ended September 30, 2008, decreased $10 million and $33 million, respectively, as compared with the same periods in 2007, primarily due to the conversion and redemption of the mandatorily redeemable convertible preferred stock, which reduced the related dividends paid during the 2008 periods (which were recorded as interest expense in the accompanying condensed consolidated statements of operations in Part I, Item 1).

Other, Net
Other, net for the three and nine months ended September 30, 2008, increased $38 million and $75 million, respectively, as compared with the same periods in 2007, primarily due to $40 million and $59 million in patent infringement settlements at Electronics for the respective 2008 periods. Other, net includes interest income for all periods presented.

NORTHROP GRUMMAN CORPORATION

Federal and Foreign Income Taxes
The company's effective tax rate on earnings from continuing operations for the three months ended September 30, 2008, was 31.4 percent compared with 32.9 percent for the same period in 2007. For the nine months ended September 30, 2008, the company's effective tax rate on earnings from continuing operations was 33.6 percent compared with 32.3 percent for the same period in 2007. During the third quarter of 2008, the company recognized net tax benefits of $21 million, which were primarily attributable to a settlement agreement reached with the Internal Revenue Service's Joint Committee on Taxation with respect to the audit of TRW 1999-2002 tax returns. During the second quarter of 2007, the company entered into a partial settlement agreement with the IRS regarding its audits of the company's tax returns for the years ended December 31, 2001 through December 31, 2003. As a result of this settlement in 2007, the company recognized tax benefits of $16 million.

Discontinued Operations
Discontinued operations for the three and nine months ended September 30, 2008, and 2007, primarily represents the net operating results and after-tax gain on sale of the Electro-Optical Systems business formerly reported in the Electronics segment. The 2007 periods also include the net operating results of Interconnect Technologies. See Note 5 to the condensed consolidated financial statements in Part I, Item I.

Diluted Earnings Per Share
Diluted earnings per share from continuing operations for the three months ended September 30, 2008, were $1.50 per share, as compared with $1.41 per share in the same period in 2007. Earnings per share are based on weighted-average diluted shares outstanding of 340.1 million for the three months ended September 30, 2008, and 352.6 million for the same period in 2007.

Diluted earnings per share from continuing operations for the nine months ended September 30, 2008, were $3.65 per share, as compared with $3.86 per share in the same period in 2007. Earnings per share are based on weighted-average diluted shares outstanding of 344.5 million for the nine months ended September 30, 2008, and 355.4 million for the same period in 2007.

Diluted earnings per share from continuing operations and the weighted-average diluted shares outstanding include the dilutive effects of the mandatorily redeemable convertible preferred stock. All of the mandatorily redeemable convertible preferred stock was converted to common stock by April 2008.

See notes 4 and 7 to the condensed consolidated financial statements in Part I, Item 1.

Net Cash Provided by Operating Activities For the three months ended September 30, 2008, net cash provided by operating activities was $1.4 billion compared to $1.0 billion for the same period in 2007. The increase of $358 million, or 35 percent, was primarily due to $190 million in improved trade working capital and patent infringement settlements, and $94 million in lower income taxes paid.

For the nine months ended September 30, 2008 and 2007, net cash provided by operating activities was unchanged at $2.2 billion.

SEGMENT OPERATING RESULTS

Basis of Presentation
The company is aligned into seven segments categorized into four primary businesses. For presentation purposes, the company's seven segments are categorized into four primary businesses. The Mission Systems, Information Technology and Technical Services segments are presented as Information & Services. The Integrated Systems and Space Technology segments are presented as Aerospace. The Electronics and Shipbuilding segments are each presented as separate businesses.

NORTHROP GRUMMAN CORPORATION

During the second quarter of 2008, the company transferred certain programs and assets from the missiles business in the Mission Systems segment to the Space Technology segment. This transfer allows Mission Systems to focus on the rapidly growing command, control, communications, intelligence, surveillance, and reconnaissance business. The missiles business will be an integrated element of the company's Aerospace business growth strategy.

In January 2008, the Newport News and Ship Systems businesses were realigned into a single segment called Northrop Grumman Shipbuilding. Previously, these businesses were separate operating segments which were aggregated into a single segment for financial reporting purposes. In addition, certain Electronics businesses were transferred to Mission Systems during the first quarter of 2008.

Sales and segment operating income information in the following tables have been revised, where applicable, to reflect the above realignments for all periods presented.

                                           Three Months Ended         Nine Months Ended
                                              September 30              September 30
     $ in millions                          2008         2007         2008         2007
     Sales and Service Revenues
     Information & Services
     Mission Systems                     $  1,417      $ 1,249     $  4,103     $  3,696
     Information Technology                 1,085        1,107        3,385        3,288
     Technical Services                       607          573        1,684        1,644

     Total Information & Services           3,109        2,929        9,172        8,628
     Aerospace
     Integrated Systems                     1,345        1,255        4,043        3,761
     Space Technology                       1,079        1,001        3,219        3,058

     Total Aerospace                        2,424        2,256        7,262        6,819
     Electronics                            1,814        1,577        5,044        4,733
     Shipbuilding                           1,451        1,469        4,403        3,984
     Intersegment eliminations               (417 )       (360 )     (1,148 )     (1,101 )

     Total sales and service revenues    $  8,381      $ 7,871     $ 24,733     $ 23,063

     Segment Operating Income
     Information & Services
     Mission Systems                     $    128      $   125     $    389     $    370
     Information Technology                    37           72          208          248
     Technical Services                        31           28           93           88

     Total Information & Services             196          225          690          706
     Aerospace
     Integrated Systems                       144          145          457          454
     Space Technology                          90           79          265          242

     Total Aerospace                          234          224          722          696
     Electronics                              264          211          675          592
     Shipbuilding                             118          183           26          396
     Intersegment eliminations                (44 )        (27 )       (103 )        (84 )

     Total segment operating income      $    768      $   816     $  2,010     $  2,306

Operating Performance Assessment and Reporting - The company manages and . . .