Summary of NORTHROP GRUMMAN CORP /DE/

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
Political and Economic Environment
The U.S. Government continues to face substantial fiscal and economic challenges that affect funding for its non-discretionary and discretionary budgets. Part I of the Budget Control Act of 2011 (Budget Control Act) provided for a reduction in defense budgets by at least $487 billion over a ten year period. Part II provided the potential for substantial additional reductions, through a process known as "sequestration." The President's proposed fiscal year (FY) 2013 budget represented a slight decline for defense from FY 2012. While Congress has not passed a FY 2013 budget, it did pass a six-month continuing resolution that funds the U.S. Government through March 27, 2013. This continuing resolution restricts new starts and provides for discretionary spending levels that represent a slight increase over the FY 2012 budget. It is unclear whether annual appropriations bills will be passed during FY 2013. The U.S. Government may operate under a continuing resolution for all of FY 2013, restricting new contract or program starts for that year.
The American Taxpayer Relief Act of 2012 was enacted in January 2013. It addressed a number of tax code provisions and certain spending issues but left in place the sequester (although delaying its implementation to March 1, 2013) and did not address other fiscal matters such as the debt ceiling. The nation's debt ceiling is currently expected to be reached during the first half of 2013. Congress and the Administration continue to debate these issues and the terms of a possible national fiscal approach. The outcome of that debate could have a significant impact on future defense spending plans. While the President's proposed FY 2014 budget is scheduled for release in February 2013, its delivery may be delayed given these unresolved broad fiscal matters.
The Congressional budget process to finalize FY 2013 defense spending also has been marked by continued uncertainty and significant debate, increasing the possibility of sequestration occurring. As noted above, the Budget Control Act calls for additional substantial defense spending reductions through sequestration, if Congress is unable to agree on a budget that conforms with the Budget Control Act requirements. Should sequestration, as currently mandated, be implemented in March 2013, absent any other changes, we expect it would have serious negative consequences for the security of our country, the defense industrial base, including Northrop Grumman, and the customers, employees, suppliers, investors, and communities that rely on the companies in the defense industrial base.
There continues to be much uncertainty also regarding how sequestration would be implemented, if it were to go into effect. There are many variables in how the law could be applied that make it difficult to determine the specific impacts. However, we expect that sequestration, as currently provided for under the Budget Control Act, would result in lower revenues, profits and cash flows for our company.
Members of Congress are discussing various options to address sequestration's automatic spending cuts. While we cannot predict the outcome of these efforts, it is likely that budget decisions made in this environment will have long-term consequences for our company and the entire defense industry.
In addition to fiscal and budgetary constraints, we expect defense spending to be affected by the drawdown of U.S. force levels tied to current major overseas deployments and other shifts in defense missions and priorities. As overall defense spending declines, the Department of Defense (DoD) is continuing to re-evaluate the role and structure of the U.S. military. In 2012, the DoD announced a new defense strategy intended to guide its priorities and budgeting decisions. The guidance calls for the U.S. military to project power globally and operate effectively in all domains, including cybersecurity, and it places particular emphasis on Asia Pacific as an area of strategic focus. We believe that spending on recapitalization, modernization and maintenance of defense, intelligence, and homeland security assets will continue to be a national priority. Future defense spending is expected to include the development and procurement of new manned and unmanned military platforms and systems along with advanced electronics and software to enhance the capabilities of existing individual systems and provide real-time integration of individual surveillance, information management, strike, and battle management platforms. We expect significant new competitive opportunities to include long range strike, missile defense, command and control, network communications, enhanced situational awareness, satellite systems, restricted programs, cybersecurity, technical services and information technology contracts, as well as numerous international and homeland security programs.
See Risk Factors located in Part I, Item 1A for a more complete description of risks we face.

Table of Contents

NORTHROP GRUMMAN CORPORATION

Operating Performance Assessment and Reporting We manage and assess the performance of our business based on our performance on contracts and programs (two or more closely-related contracts), with consideration given to the Critical Accounting Policies, Estimates and Judgments described later in this section. Revenue on our portfolio of long-term contracts is generally recognized using the percentage of completion method, primarily the cost-to-cost method, but in some cases the units-of-delivery method of percentage of completion accounting. As a result, sales tend to fluctuate in concert with costs across our large portfolio of contracts. Due to Federal Acquisition Regulations (FAR) rules that govern our business, most types of costs are allowable, and we do not focus on individual cost groupings (such as manufacturing, engineering, and design labor costs, subcontractor costs, material costs, overhead costs, and general and administrative costs), as much as we do on total contract costs, which is the key driver of both sales and operating income.
Our contract management process involves the use of contract estimates-at-completion (EACs) that are generally prepared and evaluated on a bottoms-up basis at least annually and reviewed on a quarterly basis over the contract's period of performance. These EACs include an estimated contract operating margin based initially on the contract award amount, adjusted to reflect estimated risks related to contract performance. These risks typically include technical risk, schedule risk and performance risk based on our evaluation of the contract effort. Similarly, the EACs include identified opportunities for operating margin rate improvement. Over the contract's period of performance, our program management organizations perform evaluations of contract performance and adjust the contract revenue and cost estimates to reflect the latest reliable information available.
Our business and program management organizations are comprised of skilled professional managers whose objective is to satisfy the customer's expectations, deliver high quality products and services, and manage contract risks and opportunities to achieve an appropriate operating margin rate on the contract. Our comprehensive business and contract management process is a coordinated process involving personnel with expertise from various disciplines including production control, contracts, cost management, mission assurance and quality, finance and supply chain, among others. As part of this overall contract management function, these personnel monitor compliance with our critical accounting policies related to contract accounting and compliance with U.S. Government regulations. Contract operating income and period-to-period contract operating margin rates are adjusted over the contract's period of performance to reflect the latest estimated revenue and cost for the contract, including changes in the risks and opportunities affecting the contract. Such adjustments may have a favorable or unfavorable effect on operating income depending upon the specific conditions affecting each contract.
In evaluating our operating performance, we look primarily at changes in sales and operating income, including the effects of meaningful changes in operating income as a result of changes in contract estimates. 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 first focuses around our four segments before distinguishing between products and services. Changes in sales are generally described in terms of volume, deliveries or other indicators of sales activity, and contract mix. For purposes of this discussion, volume generally refers to increases or decreases in cost or sales from production/service activity levels or delivery rates. Performance refers to changes in contract margin rates for the period, primarily related to the changes in estimates referred to above.

CONSOLIDATED OPERATING RESULTS
Selected financial highlights, excluding the results of discontinued operations,
are presented in the table below:
                                               Year Ended December 31
$ in millions, except per share amounts    2012         2011         2010
Sales                                    $25,218      $26,412      $28,143
Operating costs and expenses              22,088       23,136       25,316
Operating income                           3,130        3,276        2,827
Operating margin rate                       12.4 %       12.4 %       10.0 %
Interest expense                          ($ 212 )     ($ 221 )     ($ 269 )
Federal and foreign income tax expense     $ 987        $ 997        $ 462
Effective income tax rate                   33.3 %       32.3 %       19.5 %
Diluted earnings per share                $ 7.81       $ 7.52       $ 6.82
Cash provided by continuing operations   $ 2,640      $ 2,347      $ 2,056

Table of Contents

NORTHROP GRUMMAN CORPORATION

Consolidated operating results for the year ended December 31, 2012, reflect our customer's overall lower spending levels, lower sales due to our portfolio shaping actions and our focus on working capital. Our margin rates and cash provided by operating activities demonstrate strong operating performance, and our continued focus on performance and affordability, as further discussed below.
Segment operating income, as reconciled below, is a non-GAAP measure and is used by management as an internal measure of the financial performance of our individual operating segments.

                                   Year Ended December 31
$ in millions                   2012        2011        2010
Segment operating income       $3,176      $3,055      $3,010
Segment operating margin rate    12.6 %      11.6 %      10.7 %

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

                                                    Year Ended December 31
$ in millions                                    2012        2011        2010
Segment operating income                        $3,176      $3,055      $3,010
   FAS pension expense in accordance with GAAP    (374 )      (238 )      (461 )
   Pension expense in accordance with CAS          506         638         471
Net FAS/CAS pension adjustment                     132         400          10
Unallocated corporate expenses                    (168 )      (166 )      (182 )
Other                                              (10 )       (13 )       (11 )
Total operating income                          $3,130      $3,276      $2,827

For financial statement purposes, we account for our employee pension plans in accordance with GAAP under Financial Accounting Standards (FAS). We charge the costs of these plans to our contracts in accordance with the FAR and the related Cost Accounting Standards (CAS) that govern such plans. The net FAS/CAS pension adjustment is pension expense determined in accordance with GAAP less pension expense charged to contracts and included in segment operating income. Unallocated corporate expenses generally include the portion of corporate expenses, other than FAS pension costs, not considered allowable or allocable under applicable CAS and FAR rules, and therefore not allocated to the segments, such as a portion of management and administration, legal, environmental, certain compensation and retiree benefits, and other expenses. Sales
2012 - Sales for 2012 decreased $1.2 billion, or 5 percent, as compared to 2011, reflecting lower sales in three of our four operating segments.
2011 - Sales for 2011 decreased $1.7 billion, or 6 percent, as compared to 2010, reflecting lower sales at all four operating segments.
The table below shows the variances in segment sales from the respective prior years:

                                     Variance from Prior Year
$ in millions                        2012               2011
Aerospace Systems                $ 13      0 %     ($472 )    (5 %)
Electronic Systems               (422 )   (6 %)     (241 )    (3 %)
Information Systems              (565 )   (7 %)     (474 )    (6 %)
Technical Services               (174 )   (5 %)     (512 )   (14 %)
Intersegment sales elimination    (46 )   (2 %)      (32 )    (2 %)

For further information by segment refer to the Segment Operating Results below, and for product and service detail, refer to the Product and Service Analysis section that follows.

Table of Contents

NORTHROP GRUMMAN CORPORATION

Operating Costs and Expenses
Operating costs and expenses are primarily comprised of labor, material,
subcontractor, and overhead costs, and are generally allocated to contracts as
they are incurred. In accordance with industry practice and the regulations that
govern cost accounting requirements for government contracts, most general
management and corporate expenses incurred at the segment and corporate
locations are considered allowable and allocable costs. These general and
administrative costs are generally allocated on a systematic basis to contracts
in progress.
Operating costs and expenses consist of the following:
                                  Year Ended December 31
$ in millions                  2012        2011        2010
Product and service costs     $19,638     $20,786     $22,849
General and administrative      2,450       2,350       2,467
Operating costs and expenses  $22,088     $23,136     $25,316

2012 - Product and service costs for 2012 decreased $1.1 billion, or 6 percent, as compared to 2011. The primary driver of the reduction in product and service costs was reduced volume at Electronic Systems, Information Systems and Technical Services. General and administrative expenses as a percentage of total sales increased to 9.7 percent in 2012, from 8.9 percent in 2011; the increase includes the impact of lower sales, higher indirect costs related to compensation accruals and cost classification changes to standardize cost accounting practices at one of our segments, as well as higher bid and proposal expenses.
2011 - Product and service costs for 2011 decreased $2.1 billion, or 9 percent, as compared to 2010. The primary driver of the reduction in product and service costs is reduced volume at all four of our segments, with Aerospace Systems, Information Systems and Technical Services driving the majority of the decrease. General and administrative expenses as a percentage of total sales was comparable at 8.9 percent.
For the product and service costs detail, see the Product and Service Analysis section that follows.
Operating Income
We define operating income as sales less operating costs and expenses, which includes general and administrative expenses. Changes in estimated sales, operating costs and expenses, and the resulting operating income related to our contracts accounted for using the percentage-of-completion method are recorded using the cumulative catch-up method of accounting. The aggregate effects of these favorable and unfavorable changes in our estimated costs at completion, across our portfolio of contracts, can have a significant effect upon our reported sales and operating income in each of our reporting periods. Cumulative catch-up operating income adjustments are presented in the table below:

                                      Year Ended December 31
$ in millions                       2012        2011       2010
Favorable adjustments              $1,270      $1,123      $945
Unfavorable adjustments              (285 )      (385 )    (270 )
Net operating income adjustments    $ 985       $ 738      $675

Cost reduction initiatives to increase our competitiveness contributed to the net favorable operating income adjustments. Our cost management activities have led to overall improved contract performance, reflected in both increased favorable adjustments and lower unfavorable adjustments. Segment Operating Income
Segment operating income is defined as operating income less certain corporate-level expenses that are not considered allowable or allocable under applicable CAS and FAR and the net FAS/CAS pension difference.

Table of Contents

NORTHROP GRUMMAN CORPORATION

The table below shows the variances in segment operating income from the
respective prior years:
                                        Variance from Prior Year
$ in millions                            2012               2011
Aerospace Systems                      $ 1      0 %     $ 4       0 %
Electronic Systems                     117     11 %      47       5 %
Information Systems                     (5 )   (1 %)     10       1 %
Technical Services                       8      3 %      11       4 %

Intersegment earnings elimination - 0 % (27 ) (12 %)

2012 - Segment operating income in 2012 increased $121 million, or 4 percent, as compared to 2011, driven by a number of factors including improved performance, particularly at Electronic Systems. Improved performance reflects mitigation of contract risks and cost reduction initiatives, as well as portfolio shaping efforts. The increase in segment operating margin rate reflects this improved segment performance on lower revenue.
2011 - Segment operating income in 2011 increased $45 million, or 1 percent, as compared to 2010, driven by improved program performance, which more than offset the impact of lower sales.
Net Pension Adjustment
The net FAS/CAS pension adjustment in 2012 decreased $268 million, as compared to 2011, primarily due to increased GAAP pension expense resulting from amortization of prior year actuarial losses and decreased CAS pension expense allocated to the operating segments due to the design change in the company's defined benefit pension plans adopted in December 2011. The net FAS/CAS pension adjustment in 2011 increased $390 million, as compared to 2010, primarily due to decreased GAAP pension expense, primarily resulting from higher than estimated returns on a larger amount of pension plan assets as of the beginning of the year.
Unallocated Corporate Expenses
Unallocated corporate expenses for 2012 were comparable with the prior year. Unallocated corporate expenses for 2011 decreased $16 million, or 9 percent, as compared with 2010, primarily due to a decrease in stock-based compensation. Interest Expense
Interest expense declined in both 2012 and 2011 by $9 million and $48 million, respectively, as compared to the respective prior years. The decrease from 2010 to 2011 is primarily due to a lower weighted average interest rate resulting from our debt refinancing in November 2010. Federal and Foreign Income Taxes
2012 - Our effective tax rate on earnings from continuing operations for 2012 was 33.3 percent, as compared with 32.3 percent in 2011. The higher effective tax rate reflects the change in net tax benefits related to the absence of research tax credits, which expired at the end of 2011. Although the American Taxpayer Relief Act of 2012 extended the research tax credit through 2013, it was not enacted until January 2013. Therefore, the 2012 research credit will be recorded in the first quarter of 2013.
2011 - Our effective tax rate on earnings from continuing operations for 2011 was 32.3 percent, as compared with 19.5 percent in 2010. In 2010, we recognized net tax benefits of $298 million to reflect the final approval from the IRS and the U.S. Congressional Joint Committee on Taxation of the IRS' examination of our tax returns for the years 2004 through 2006. Diluted Earnings Per Share
2012 - Our diluted earnings per share increased by $0.29, or 4 percent. The higher diluted earnings per share reflects the full impact of 2011 share repurchases, which were largely purchased in the second half of 2011, the effect of our 2012 share repurchases and the higher segment operating income, partially offset by lower earnings reflecting the lower net FAS/CAS pension adjustment. 2011 - Our diluted earnings per share increased by $0.70, or 10 percent. The higher diluted earnings per share reflects higher earnings and the effects of our share repurchases.
Cash Provided by Continuing Operations
2012 - Cash provided by continuing operations for 2012 was $2.6 billion, as compared with $2.3 billion in 2011. Cash provided by continuing operations reflects lower pension contributions, partially offset by higher income taxes

Table of Contents

NORTHROP GRUMMAN CORPORATION

paid. In 2012, we contributed $367 million to our pension plans, of which $300 million was voluntarily pre-funded, as compared with $1.1 billion in 2011, of which $1.0 billion was voluntarily pre-funded.
2011 - Cash provided by continuing operations in 2011 was $2.3 billion, as compared with $2.1 billion in 2010. The increase in 2011 reflects lower tax payments, timing of trade working capital and higher pension contributions. In 2011, we contributed $1.1 billion to our pension plans, of which $1.0 billion was voluntarily pre-funded, as compared with $789 million in 2010, of which $728 million was voluntarily pre-funded.
SEGMENT OPERATING RESULTS
Basis of Presentation
We are aligned in four reportable segments: Aerospace Systems, Electronic Systems, Information Systems and Technical Services. This section discusses sales, segment operating income and operating margin rates by segment. The reconciliation of segment sales to total sales is provided in Note 4 to the consolidated financial statements in Part II, Item 8, with the difference being intersegment sales eliminations. The reconciliation of segment operating income to total operating income, as well as a discussion of the reconciling items, is included in the Consolidated Operating Results section above. For purposes of the discussion in this Segment Operating Results section, references to operating income and operating income margin rate reflect segment operating income and segment operating margin rate.
On January 1, 2012, we transferred our missile business (primarily the Intercontinental Ballistic Missile (ICBM) program) from the Aerospace Systems segment to our Technical Services segment. The segment sales and segment operating income for the years ended December 31, 2011 and 2010, have been recast to reflect the missile business transfer. Sales of $494 million and $474 million, and segment operating income of $44 million and $43 million, were transferred from Aerospace Systems to Technical Services for the years ended December 31, 2011 and 2010, respectively.
For a more complete description of each segment's products and services, see the business descriptions in Part I, Item 1.

AEROSPACE SYSTEMS
                              Year Ended December 31
$ in millions             2012        2011         2010
Sales                    $9,977      $9,964      $10,436
Operating income          1,218       1,217        1,213
Operating margin rate      12.2 %      12.2 %       11.6 %

2012 - Aerospace Systems sales for 2012 were comparable to the prior year. Sales of unmanned systems increased approximately $280 million, primarily related to ramping up on the NATO Alliance Ground Surveillance (AGS) and Fire Scout programs. Additionally, there was higher volume of approximately $200 million on the F-35 program due to deliveries on LRIP 5, the first F-35 contract accounted for under the units-of-delivery method. These increases were offset by the termination of a weather satellite program, which reduced sales by approximately $175 million, as well as lower sales on the Joint Surveillance Target Attack Radar System (JSTARS), F/A-18 and certain restricted space programs. Operating income and margin rate for 2012 were comparable to the prior year. The operating income and margin rate reflect approximately $90 million lower operating income from the F/A-18 program's lower volume and transition from the multi-year 2 contract to the lower margin multi-year 3 contract, principally offset by performance improvements in space systems and higher margin rates and volume on sales of unmanned systems.
2011 - Aerospace Systems sales for 2011 decreased $472 million, or 5 percent, as compared with 2010. The decrease was primarily due to approximately $430 million lower sales in space systems due to reduced funding for weather satellite programs and the James Webb Space Telescope (JWST), as well as lower volume for several other space programs. Military aircraft systems declined approximately $130 million primarily due to lower volume on the F-35 program, which transitioned to a units-of-delivery revenue recognition method beginning with low rate initial production lot 5, the completion of the aerial targets program and lower volume on EA-18G Growler, offset by higher volume on Long Endurance Multi-Intelligence Vehicle (LEMV) and JSTARS. These decreases were partially offset by higher sales at advanced concepts and technology, primarily due to increased volume on restricted programs.

Table of Contents

NORTHROP GRUMMAN CORPORATION

Operating income for 2011 was comparable with the prior year, and operating margin rate increased to 12.2 percent from 11.6 percent. The increase is primarily due to improved performance across several programs at Aerospace Systems and lower amortization expense on purchased intangibles, partially offset by an unfavorable adjustment for performance incentives on a space program and overall lower sales volume discussed above.

ELECTRONIC SYSTEMS
                             Year Ended December 31
$ in millions             2012        2011        2010
Sales                    $6,950      $7,372      $7,613
Operating income          1,187       1,070       1,023
Operating margin rate      17.1 %      14.5 %      13.4 %

2012 - Electronic Systems sales for 2012 decreased $422 million, or 6 percent, as compared with 2011. The decrease was largely due to lower volume of . . .