NORTHROP GRUMMAN CORP /DE/ Management’s Discussion and Analysis of Financial Condition and Results of Operations (Form 10-K)

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PREVIEW

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 ended December 31, 2020 ("2020 Annual Report on Form 10-K").
Disposition of IT and Mission Support Services Business
Effective January 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 the Vinnell 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. See Note 2 to the consolidated financial statements for further
information regarding the disposition.
COVID-19
COVID-19 was first reported in late 2019. In March 2020, the World Health
Organization characterized COVID-19 as a global pandemic, and the President
declared a national emergency concerning the COVID-19 outbreak. In the almost
two years since then, the pandemic has dramatically impacted the global health
and economic environment, including millions of confirmed cases and deaths,
business slowdowns or shutdowns, labor shortfalls, supply chain challenges,
regulatory challenges, and market volatility. We discussed in some detail in our
Annual Report on Form 10-K for the fiscal year ended December 31, 2020, and
subsequent SEC filings in 2021, 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.
The company's leadership, our crisis management and business resumption teams,
and local site leadership continue closely to monitor and address the pandemic
and related developments, including the impact on our company, our employees,
our customers, our suppliers and our communities. The company has considered and
continues to consider and be guided by health data and evolving guidance from
the Centers for Disease Control and Prevention (CDC), in particular, as well as
other health organizations globally, federal, state and local governmental
authorities, and our customers, among others. We have taken, and continue to
take, robust actions to help protect the health, safety and well-being of our
employees, to support continued performance, to support our suppliers and local
communities, and to continue to serve our customers. Our goals have been, and
continue to be 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 depending on the
spread of COVID-19 and applicable government requirements, the needs of our
employees, the needs of our customers and the needs of our business.
Over the course of 2021, COVID-19 case rates and the health and economic impacts
of the pandemic fluctuated dramatically in different communities in the U.S. and
globally, particularly with the spread of new variants. But we continued to see
a prolonged impact on the economy, our industry, and our company, with increased
challenges for customers and suppliers, labor shortages, supply chain
challenges, and increasing inflation, among other impacts. We expect these and
other impacts to continue and they could worsen, depending on the future course
of the pandemic and actions taken in connection with it.
In the U.S., the Food and Drug Administration issued emergency use authorization
for COVID-19 vaccines and the government began extensive efforts to administer
them. The company also has taken various steps to encourage and facilitate
vaccination access for our employees, in accordance with federal guidance. We
have provided paid leave and flexibility for employees to get vaccinated, and
strongly encouraged our workforce to take care of themselves and their
colleagues. In September 2021, the White House issued an executive order and
guidance from the Safer Federal Workforce Task Force broadly requiring many
U.S.-based federal contractors to be fully vaccinated by December 8, 2021 (or to
have an approved accommodation). In early November 2021, the federal government
extended that deadline to January 18, 2022. On December 7, 2021, a federal
district judge issued an order, temporarily suspending the government from
enforcing the federal contractor mandate. That order is on appeal. State and
local governments are also taking actions related to the pandemic, imposing
additional and varying requirements on industry. We have taken and are taking
steps strongly to encourage our employees to be fully vaccinated (or to have an
approved accommodation) to protect our workplace and to position the company to
comply with the executive order, guidance, and related contract terms, if and as
necessary, as we continue to evaluate the evolving situation and our customers'
requirements. Evolving government requirements, including regarding a vaccine
mandate, along with the broader impacts of the continuing pandemic, could
significantly impact
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our workforce and performance, as well as those of our suppliers, and result in
costs that we may not be able to recover fully. The company continues to take
robust actions globally to protect the health, safety and well-being of our
employees, and to serve our customers with continued performance. We also
continue to take steps to support our suppliers, with a particular focus on
critical small and midsized business partners, including passing through
increased progress payments from the DoD to our suppliers and accelerating
payments to certain suppliers.
The company's fourth quarter 2021 revenue and operating income were affected by
the impact of the COVID-19 pandemic on the company and the broader economic
environment, including through a tightened labor market, elevated levels of
employee leave, evolving government requirements, and supply chain challenges.
These factors are expected to continue and could worsen and affect further our
ability (and that of our suppliers) to maintain a qualified workforce and to
perform fully for our customers (including with respect to cost and schedule),
with delayed or reduced sales and additional liabilities, losses and costs, that
we may not be able to recover fully. Our employees, customers and suppliers, the
company, our economy and our global community face both continuing and new or
evolving challenges related to the pandemic, and we cannot predict how this
dynamic situation will evolve or the impact it will have on the company, or our
financial position, results of operations and/or cash flows. For further
information on the pandemic and the potential impact to the company of COVID-19,
see "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Liquidity and Capital Resources" below and "Risk Factors."
Global Security and Economic Environment
The U.S. and its allies continue to face a global security environment of
heightened tensions and instability, threats from state and non-state actors,
including major global powers, as well as terrorist organizations, emerging
nuclear tensions, diverse regional security concerns and political instability.
Global threats persist across all domains, from undersea to space to cyber. 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 priorities.
The global geopolitical and economic environments also continue to be impacted
by uncertainty. Geopolitical relationships are changing and global economic
growth is expected to remain in the low single digits in 2022 reflecting the
impact of and uncertainty surrounding geopolitical tensions globally and
financial market volatility and the COVID-19 pandemic. The global economy may
also be affected by the residual legal, regulatory and economic impacts of
Britain's exit from the European Union, the full impacts of which are complex
and gradually becoming evident. Rising inflation also could lead to increased
interest rates, raising the cost of borrowing for the federal government, which
could impact other spending priorities. Additionally, economic tensions and
changes in international trade policies, including higher tariffs on imported
goods and materials and renegotiation of free trade agreements, could impact the
global market for defense products, services and solutions.
U.S. Political and Economic Environment
On May 28, 2021, the Administration released its budget request for FY 2022. The
budget proposed $753 billion for national defense programs and $770 billion in
non-defense discretionary funding. It continues to be the subject of debate in
Congress. The Administration's budget request included funding for an
infrastructure and economic recovery plan and an education and economic support
plan. On November 15, 2021, the President signed into law the $1.2 trillion
Infrastructure and Investment and Jobs Act. Enactment of the infrastructure plan
and any future spending plans, as well as the costs of the pandemic (as
discussed more above), may have broader implications for the defense industry,
our customers' budgets and priorities, and the overall economic environment,
including the national debt. It is difficult to predict the specific course of
future defense budgets. However, the threat to U.S. national security remains
very substantial. We believe that our capabilities, particularly in space,
missiles, missile defense, hypersonics, counter-hypersonics, survivable aircraft
and mission systems should help our customers defend against future threats and,
as a result, continue to allow for long-term profitable growth in our business.
FY 2022 appropriations have not been enacted to date. On September 30, 2021, a
continuing resolution was enacted, providing funding generally at FY 2021 levels
through December 3, 2021; the continuing resolution was further extended through
February 18, 2022. Congressional deliberations over FY 2022 appropriations have
demonstrated broad support for national security, with increased funding
proposed in certain areas for national defense above the Administration's budget
request. It remains uncertain whether and, if so, when the government will
approve FY 2022 appropriations, with which programs funded at what levels, and
for how long the government will operate under a continuing resolution, with
potential impacts on our programs and new starts, in particular.
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The Bipartisan Budget Act of 2019 suspended the debt ceiling through July 31,
2021. In October 2021, the statutory debt limit was increased by $480 billion
and, in December 2021, was further increased by $2.5 trillion, which is
currently expected to allow the Treasury Department to finance the government
into 2023.
The political environment, federal budget and debt ceiling are expected to
continue to be the subject of considerable debate, which could have material
impacts on defense spending broadly and the company's programs in particular.
For further information on the risks we face from the current political and
economic environment, see "Risk Factors."
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 our U.S.
government business, most types of costs are allocable to U.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. 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).
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 in the 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.
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Some financial highlights are presented in the table below:

                                                              Year Ended December 31                               % Change in
$ in millions, except per share amounts              2021              2020              2019                 2021                2020
Sales                                             $ 35,667          $ 36,799          $ 33,841                     (3) %              9  %
Operating costs and expenses                        31,996            32,734            29,872                     (2) %             10  %

Operating costs and expenses as a % of revenue 89.7% 89.0%

           88.3  %
Gain on sale of business                             1,980                 -                 -                        NM                NM
Operating income                                     5,651             4,065             3,969                     39  %              2  %
Operating margin rate                                 15.8  %           11.0  %           11.7  %
Mark-to-market pension and OPB benefit (expense)     2,355            (1,034)           (1,800)                  (328) %            (43) %
Federal and foreign income tax expense               1,933               539               300                    259  %             80  %
Effective income tax rate                             21.6  %           14.5  %           11.8  %
Net earnings                                         7,005             3,189             2,248                    120  %             42  %
Diluted earnings per share                           43.54             19.03             13.22                    129  %             44  %


Sales

The tables below reconcile sales to organic sales:

                                                                 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  %


                                                                 Year Ended December 31
                                                                    2020                                        2019
                                                                 IT services    Organic                      IT services    Organic         Organic sales %
$ in millions                                          Sales        sales        sales             Sales        sales        sales              change
Aeronautics Systems                                 $ 12,169    $        -    $ 12,169          $ 11,116    $        -    $ 11,116                     9  %
Defense Systems                                        7,543        (1,637)      5,906             7,495        (1,594)      5,901                     -  %
Mission Systems                                       10,080          (527)      9,553             9,410          (555)      8,855                     8  %
Space Systems                                          8,744          (182)      8,562             7,425          (180)      7,245                    18  %
Intersegment eliminations                             (1,737)           17      (1,720)           (1,605)           24      (1,581)
Total                                               $ 36,799    $   (2,329)   $ 34,470          $ 33,841    $   (2,305)   $ 31,536                     9  %


2021 sales decreased $1.1 billion, or 3 percent, due to a $2.2 billion reduction
in sales related to the IT services divestiture. 2021 organic sales increased
$1.0 billion, or 3 percent due to higher sales at Space and Mission Systems,
partially offset by lower sales at Aeronautics Systems and Defense Systems. 2020
sales included a $444 million sale of equipment to a restricted customer at
Aeronautics Systems.
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.
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Operating Income and Margin Rate
2021 operating income increased $1.6 billion, or 39 percent, primarily due to
the IT services divestiture, including the $2.0 billion pre-tax gain on sale and
$192 million of unallocated corporate expense for unallowable state taxes and
transaction costs, partially offset by a $288 million reduction in the FAS/CAS
operating adjustment. Lower non-divestiture-related unallocated corporate
expenses were partially offset by higher deferred state taxes principally
related to the company's 2021 MTM benefit. 2021 operating margin rate increased
to 15.8 percent from 11.0 percent reflecting the items above.
2021 G&A costs as a percentage of sales increased to 10.1 percent from 9.3
percent, primarily due to an increase in investments for future business
opportunities and a lower G&A cost mix in the divested IT services business.
For further information regarding product and service operating costs and
expenses, see "Product and Service Analysis" below.
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                                                2021          2020          2019
Actuarial gains (losses) on projected benefit obligation   $ 1,163      $ (3,570)     $ (4,866)
Actuarial gains on plan assets                               1,192         2,536         3,066

MTM benefit (expense)                                      $ 2,355      $ (1,034)     $ (1,800)


2021 MTM benefit of $2.4 billion was primarily driven by a 30 basis point
increase in the discount rate from year end 2020 and actual net plan asset
returns of approximately 10.9 percent compared to our 7.5 percent asset return
assumption.
Federal and Foreign Income Taxes
The 2021 effective tax rate (ETR) increased to 21.6 percent from 14.5 percent in
the prior year period primarily due to federal income taxes resulting from the
IT services divestiture, including $250 million of income tax expense related to
$1.2 billion of nondeductible goodwill in the divested business. The company's
2021 MTM benefit did not significantly impact the 2021 ETR; however, MTM expense
in 2020 reduced the 2020 ETR by 1.3 percentage points. See Note 7 to the
consolidated financial statements for additional information.
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Net Earnings
The table below reconciles net earnings to transaction-adjusted net earnings:
                                                                        Year Ended December 31                              % Change in
$ in millions                                                   2021              2020             2019                2021                2020
Net earnings                                                 $  7,005          $ 3,189          $ 2,248                    120  %             42  %
MTM (benefit) expense                                          (2,355)           1,034            1,800                   (328) %            (43) %
MTM-related deferred state tax expense (benefit)(1)               124              (54)             (81)                  (330) %            (33) %
Federal tax expense (benefit) of items above(2)                   469             (206)            (361)                  (328) %            (43) %
MTM adjustment, net of tax                                     (1,762)             774            1,358                   (328) %            (43) %
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                            $  4,123          $ 3,963          $ 3,606                      4  %             10  %


(1)The deferred state tax impact was calculated using the company's blended
state tax rate of 5.25 percent in 2021 and 2020 and 4.50 percent in 2019 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 $62 million of incremental tax expense related
to $1.2 billion of nondeductible goodwill in the divested business.
(4)The federal tax impact was calculated by applying the 21 percent federal
statutory rate to the adjustment items and also includes $250 million of
incremental tax expense related to $1.2 billion of nondeductible goodwill in the
divested business.
2021 net earnings increased $3.8 billion, or 120 percent, principally due to a
$2.5 billion increase in our MTM benefit, net of tax, and a $1.1 billion
increase associated with the IT services divestiture, net of tax.
Transaction-adjusted net earnings increased $160 million, or 4 percent,
primarily due to lower unallocated corporate expense and higher segment
operating income, partially offset by higher income tax expense.

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Diluted Earnings Per Share
The table below reconciles diluted earnings per share to transaction-adjusted
EPS:
                                                                        Year Ended December 31                              % Change in
                                                                2021              2020             2019                2021                2020
Diluted earnings per share                                   $  43.54          $ 19.03          $ 13.22                    129  %             44  %
MTM (benefit) expense per share                                (14.64)            6.17            10.59                   (337) %            (42) %

State deferred tax expense (profit) related to MTM per share(1)

                                                         0.77            (0.32)           (0.48)                  (341) %            (33) %

Federal tax expense (benefit) of the above items per share(2) 2.92

      (1.23)           (2.12)                  (337) %            (42) %
MTM adjustment per share, net of tax                           (10.95)            4.62             7.99                   (337) %            (42) %
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                                     $  25.63          $ 23.65          $ 21.21                      8  %             12  %


(1)The deferred state tax impact was calculated using the company's blended
state tax rate of 5.25 percent in 2021 and 2020 and 4.50 percent in 2019 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 $62 million of incremental tax expense related
to $1.2 billion of nondeductible goodwill in the divested business.
(4)The federal tax impact was calculated by applying the 21 percent federal
statutory rate to the adjustment items and also includes $250 million of
incremental tax expense related to $1.2 billion of nondeductible goodwill in the
divested business.
2021 diluted earnings per share increased $24.51, or 129 percent, principally
due to a $15.57 increase in our 2021 MTM benefit, net of tax, and a $6.96
increase associated with the IT services divestiture, net of tax.
Transaction-adjusted EPS increased $1.98, or 8 percent, reflecting a 4 percent
increase in transaction-adjusted net earnings and a 4 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


Effective during the first quarter of 2021 within Mission Systems, the
businesses of the former CIMS business area that remained with Northrop Grumman
after the IT services divestiture were merged with the Communications business
unit and F-35 Communications, Navigation and Identification programs within the
former Airborne, Sensors & Networks business area to form the Networked
Information Solutions business area. The Airborne Sensors & Networks business
area was then renamed the Airborne Multifunction Sensors business area to better
reflect its new portfolio. This change had no impact on the segment operating
results of Mission Systems as a whole.
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This section discusses segment sales, operating income and operating margin
rate. A reconciliation of segment operating income to total operating income is
provided below.
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                                        2021              2020             2019                2021                2020

Operating income                                  $  5,651          $ 4,065          $ 3,969                     39  %              2  %
Reconciliation to segment operating income:
CAS pension expense                                   (544)            (827)            (832)                   (34) %             (1) %
FAS pension service expense                            414              409              367                      1  %             11  %
FAS/CAS operating adjustment                          (130)            (418)            (465)                   (69) %            (10) %
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                                           254              322              390                    (21) %            (17) %
MTM-related deferred state tax expense
(benefit)(1)                                           124              (54)             (81)                  (330) %            (33) %
Other unallocated corporate expense                    106              273              165                    (61) %             65  %
Unallocated corporate (income) expense            $ (1,304)         $   541          $   474                   (341) %             14  %
Segment operating income                          $  4,217          $ 4,188          $ 3,978                      1  %              5  %
Segment operating margin rate                         11.8  %          11.4 

% 11.8%


(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
2021 segment operating income increased $29 million, or 1 percent. Higher
operating income at Space Systems and Mission Systems was driven by increased
volume and improved performance. Lower operating income at Defense Systems is
due to the impact of the IT services divestiture and lower operating income at
Aeronautics Systems principally relates to net unfavorable EAC adjustments on
F-35. 2021 segment operating income from the IT services business was $20
million as compared to $247 million in 2020. Segment operating income includes a
first quarter 2021 benefit of approximately $100 million due to the impact of
lower overhead rates on the company's fixed price contracts. Segment operating
margin rate increased to 11.8 percent from 11.4 percent and reflects higher
operating margin rates at Mission Systems, Defense Systems and Space Systems.
FAS/CAS Operating Adjustment
The decrease in our 2021 FAS/CAS operating adjustment is due to lower CAS
pension expense resulting from favorable plan asset returns in 2020 and changes
in certain CAS actuarial assumptions as of December 31, 2020.
Unallocated Corporate Income (Expense)
The increase in 2021 unallocated corporate income (expense) is primarily due to
a $2.0 billion pre-tax gain on the sale of our IT services business, partially
offset by $192 million of unallowable state taxes and transaction costs
associated with the divestiture. Lower non-divestiture-related unallocated
corporate expense reflects a $60 million benefit from insurance settlements
related to shareholder litigation involving the former Orbital ATK prior to the
company's acquisition, that was resolved in June 2019, as well as benefits
recognized during the year associated with changes in deferred state taxes,
partially offset by higher deferred state tax expense related to the company's
2021 MTM benefit.
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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                   2021          2020           2019
Favorable EAC adjustments     $ 1,242      $   1,082      $   1,040
Unfavorable EAC adjustments      (715)          (616)          (560)
Net EAC adjustments           $   527      $     466      $     480

Net EAC adjustments by segment are shown in the table below:

                              Year Ended December 31
$ in millions               2021            2020       2019
Aeronautics Systems   $     25             $  77      $ 143
Defense Systems            113               148         99
Mission Systems            263               216        189
Space Systems              134                33         63
Eliminations                (8)               (8)       (14)
Net EAC adjustments   $    527             $ 466      $ 480


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              2021           2020           2019            2021         2020
Sales                   $ 11,259       $ 12,169       $ 11,116              (7) %      9  %
Operating income           1,093          1,206          1,188              (9) %      2  %
Operating margin rate        9.7  %         9.9  %        10.7  %


Sales
2021 sales decreased $910 million, or 7 percent, due to lower volume in both
Manned Aircraft and Autonomous Systems. Lower sales reflect a $444 million sale
of equipment to a restricted customer in 2020, $150 million of lower F-35 sales,
lower A350 production activity, and lower volume on the B-2 Defensive Management
Systems Modernization (DMS) program and certain Global Hawk programs.
Operating Income
2021 operating income decreased $113 million, or 9 percent, principally due to
lower sales. 2021 operating margin rate decreased to 9.7 percent from 9.9
percent due to lower net favorable EAC adjustments, driven by F-35, partially
offset by improved performance on Autonomous Systems programs.
DEFENSE SYSTEMS
                                Year Ended December 31                 % Change in
$ in millions              2021          2020          2019           2021         2020
Sales                   $ 5,776       $ 7,543       $ 7,495             (23) %      1  %
Operating income            696           846           793             (18) %      7  %
Operating margin rate      12.0  %       11.2  %       10.6  %


Sales
2021 sales decreased $1.8 billion, or 23 percent, primarily due to a
$1.5 billion reduction in sales related to the IT services divestiture. 2021
organic sales decreased $236 million, or 4 percent, due to $397 million lower
sales in connection with the close-out of the contract at the Army's Lake City
ammunition plant (Lake City) and lower volume on an international training
program, partially offset by higher volume on several programs including
Republic of Korea Global Hawk Contractor Logistics Support (ROK Global Hawk
CLS), U.S. Customs and Border Protection P-3 (CBP P-3), GMLRS, B-2 sustainment
and advanced fuzes.
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Operating Income
2021 operating income decreased $150 million, or 18 percent, due to the impact
of the IT services divestiture. Operating margin rate increased to 12.0 percent
from 11.2 percent and reflects improved performance at Battle Management and
Missile Systems due to changes in mix as a result of recent contract
completions.
MISSION SYSTEMS
                                 Year Ended December 31                  % Change in
$ in millions              2021           2020           2019           2021         2020
Sales                   $ 10,134       $ 10,080       $ 9,410               1  %      7  %
Operating income           1,579          1,459         1,408               8  %      4  %
Operating margin rate       15.6  %        14.5  %       15.0  %


Sales

2021 sales increased $54 million, or 1 percent, due to higher volume across the
sector, partially offset by a $485 million reduction in sales related to the IT
services divestiture. 2021 organic sales increased $539 million, or 6 percent.
Maritime/Land Systems and Sensors sales increased primarily due to $137 million
higher volume on G/ATOR and higher marine systems volume. Airborne Multifunction
Sensors sales increased principally due to $105 million higher volume on
airborne radar programs, including SABR, and higher restricted sales, partially
offset by lower volume on airborne electronic warfare programs. Navigation,
Targeting and Survivability sales increased principally due to $124 million
higher intercompany volume largely related to GBSD ramp-up. Networked
Information Solutions sales increased principally due to higher volume on
electronic warfare programs, including JCREW, and higher intercompany volume,
partially offset by lower volume on F-35 CNI programs.
Operating Income
2021 operating income increased $120 million, or 8 percent, due to a higher
operating margin rate and higher sales. Operating margin rate increased to 15.6
percent from 14.5 percent due to higher net favorable EAC adjustments, which
reflect improved performance and the first quarter 2021 reduction in overhead
rates, the favorable resolution of certain government accounting matters in the
second quarter of 2021 and mix changes largely related to the IT services
divestiture.
SPACE SYSTEMS
                                Year Ended December 31                  % Change in
$ in millions              2021           2020          2019           2021         2020
Sales                   $ 10,608       $ 8,744       $ 7,425              21  %     18  %
Operating income           1,121           893           794              26  %     12  %
Operating margin rate       10.6  %       10.2  %       10.7  %


Sales

2021 sales increased $1.9 billion, or 21 percent, due to higher volume in both
the Launch & Strategic Missiles and Space business areas, partially offset by a
$166 million reduction in sales related to the IT services divestiture. 2021
organic sales increased $2.0 billion, or 24 percent. Launch & Strategic Missiles
sales increased primarily due to ramp-up on development programs, including a
$1.1 billion increase on GBSD and a $206 million increase on NGI. Space sales
were driven by higher volume on restricted programs and increases of $192
million on Artemis and $140 million on Next Gen OPIR.
Operating Income
2021 operating income increased $228 million, or 26 percent, due to higher sales
and a higher operating margin rate. Operating margin rate increased to 10.6
percent from 10.2 percent primarily due to higher net favorable EAC adjustments,
which were largely driven by improved performance on commercial space programs
and the first quarter 2021 reduction in overhead rates.
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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                                            2021                                       2020                                       2019
                                                             Operating Costs                            Operating Costs                            Operating Costs
Segment Information:                        Sales             and Expenses             Sales             and Expenses             Sales             and Expenses
Aeronautics Systems
Product                                  $   9,408          $        8,534          $  10,437          $        9,435          $   9,387          $        8,428
Service                                      1,662                   1,462              1,610                   1,417              1,626                   1,407
Intersegment eliminations                      189                     170                122                     111                103                      93
Total Aeronautics Systems                   11,259                  10,166             12,169                  10,963             11,116                   9,928
Defense Systems
Product                                      2,564                   2,243              3,024                   2,740              2,784                   2,572
Service                                      2,423                   2,137              3,791                   3,305              4,020                   3,513
Intersegment eliminations                      789                     700                728                     652                691                     617
Total Defense Systems                        5,776                   5,080              7,543                   6,697              7,495                   6,702
Mission Systems
Product                                      7,064                   6,017              6,744                   5,757              6,022                   5,073
Service                                      2,077                   1,695              2,557                   2,201              2,660                   2,314
Intersegment eliminations                      993                     843                779                     663                728                     615
Total Mission Systems                       10,134                   8,555             10,080                   8,621              9,410                   8,002
Space Systems
Product                                      8,832                   7,898              6,810                   6,084              5,659                   5,021
Service                                      1,637                   1,464              1,826                   1,672              1,683                   1,535
Intersegment eliminations                      139                     125                108                      95                 83                      75
Total Space Systems                         10,608                   9,487              8,744                   7,851              7,425                   6,631
Segment Totals
Total Product                            $  27,868          $       24,692          $  27,015          $       24,016          $  23,852          $       21,094
Total Service                                7,799                   6,758              9,784                   8,595              9,989                   8,769
Total Segment(1)                         $  35,667          $       31,450          $  36,799          $       32,611          $  33,841          $       29,863


(1)A reconciliation of segment operating income to total operating income is
included in "Segment Operating Results."
Product Sales and Costs
2021 product sales increased $853 million, or 3 percent, due to ramp-up on
development programs including GBSD and NGI at Space Systems, as well as higher
volume on airborne radar and land systems programs at Mission Systems. The
increase was partially offset by lower restricted sales and lower net favorable
EAC adjustments at Aeronautics Systems as well as close-out of the Lake City
contract at Defense Systems.
2021 product costs increased $676 million, or 3 percent, consistent with the
higher product sales described above.
Service Sales and Costs
2021 service sales decreased $2.0 billion, or 20 percent, primarily due to the
IT services divestiture. Year to date 2021 sales from the IT services business,
which were largely included in service sales, were $162 million as compared to
$2.3 billion in the prior year period. The reductions associated with the IT
services divestiture were partially offset by higher volume on the ROK Global
Hawk CLS and CBP P-3 programs at Defense Systems.
2021 service costs decreased $1.8 billion, or 21 percent, consistent with the
lower service sales described above.
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
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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 December 31, 2021 and 2020:
                                          2021                        2020
                                                       Total         Total
$ in millions              Funded       Unfunded      Backlog       Backlog       % Change in 2021
Aeronautics Systems      $  8,842      $  9,435      $ 18,277      $ 24,002                  (24) %
Defense Systems             5,802           547         6,349         8,131                  (22) %
Mission Systems             9,940         4,366        14,306        13,805                    4  %
Space Systems               6,210        30,904        37,114        35,031                    6  %
Total backlog            $ 30,794      $ 45,252      $ 76,046      $ 80,969                   (6) %


2021 net awards totaled $32.1 billion. Significant 2021 new awards include $6.1
billion for restricted programs (primarily at Space Systems, Mission Systems and
Aeronautics Systems), $3.2 billion for the SLS Booster Production and Operations
Contract, $2.6 billion for NGI, $2.2 billion for F-35, $1.0 billion for E-2 and
$0.9 billion for NASA's HALO module. In connection with the IT services
divestiture, the company reduced backlog by $1.4 billion during the first
quarter of 2021 ($1.0 billion at Defense Systems, $0.2 billion at Mission
Systems and $0.2 billion at Space Systems).
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 of December 31, 2021, we had cash and cash equivalents of $3.5 billion;
$295 million was held outside of the U.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 the SEC, 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 $2.0 billion, and in April 2021, we renewed our
one-year $500 million uncommitted credit facility. At December 31, 2021, there
was no balance 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. At December 31, 2021, we had $17.7 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
under U.S. government contracts. In most circumstances, our risk associated with
the purchase obligations on our U.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. At December 31,
2021, 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
$1.6 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 allow U.S. companies to defer the
employer's portion of social security taxes between March 27, 2020 and December
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 is due 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 continues to seek,
and anticipates continuing to seek, recovery for certain COVID-19-related costs
under Section
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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, the DoD has, to date, 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 what steps the DoD will continue
to take.
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                                     2021         2020         2019
Net earnings                                   $  7,005      $ 3,189      $ 2,248
Gain on sale of business                         (1,980)           -            -
Non-cash items(1)                                (1,510)       1,799        2,251
Pension and OPB contributions                      (141)        (887)       

(263)

Changes in trade working capital                    181          227        

128

Other, net                                           12          (23)       

(67)

Net cash flow generated by operating activities $3,567 $4,305 $4,297


(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.
2021 cash provided by operating activities decreased $738 million principally
due to federal and state taxes of $785 million paid in connection with the IT
services divestiture. Lower 2021 pension and OPB contributions were largely
offset by the impact of CARES Act social security tax deferrals and the 2020
increase in DoD progress payment rates.
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.
The table below reconciles net cash provided by operating activities to adjusted
free cash flow:
                                                                  Year Ended December 31                              % Change in
$ in millions                                             2021              2020             2019                2021                2020
Net cash provided by operating activities              $  3,567          $ 4,305          $ 4,297                    (17) %              -  %
Capital expenditures                                     (1,415)          (1,420)          (1,264)                     -  %             12  %
Proceeds from sale of equipment to a customer                84              205                -                    (59) %                NM
After-tax discretionary pension contributions                 -              593               95                   (100) %            524  %
Adjusted free cash flow                                $  2,236          $ 3,683          $ 3,128                    (39) %             18  %


2021 adjusted free cash flow decreased $1.4 billion, principally due to federal
and state taxes of $785 million paid related to the IT services divestiture as
well as the impact of CARES Act social security tax deferrals and the 2020
increase in DoD progress payment rates.
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Investing Cash Flow
2021 net cash provided by investing activities was $2.1 billion compared to net
cash used in investing activities of $1.2 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
2021 net cash used in financing activities increased $6.6 billion, principally
due to an increase of $3.2 billion in share repurchases and $1.2 billion in debt
repayments. 2020 net cash used in financing activities included $2.2 billion of
net proceeds from the issuance of long-term debt.
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 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 are
inherently more uncertain as to future events than production contracts, and, as
a result, there is typically more variability in those estimates, as well as
financial risk associated with unanticipated cost growth. 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
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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 2.98 percent at December 31, 2021 and 2.68 percent at
December 31, 2020.
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 the December
31, 2021 discount rate assumption would have the following estimated effects on
2021 pension and OPB obligations, which would be reflected in the 2021 MTM
expense (benefit), and 2022 expected pension and OPB expense:
                                                                25 Basis Point          25 Basis Point
$ in millions                                                  Decrease in Rate        Increase in Rate
2021 pension and OPB obligation and MTM expense (benefit)     $         1,343          $       (1,274)
2022 pension and OPB (benefit) expense                                    (44)                     40


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 the minimum threshold of 2.25 percent as of December
31, 2021, and will remain at 2.25 percent through 2027. Holding all other
assumptions constant, an increase or decrease of 25 basis points in the December
31, 2021 cash balance crediting rate assumption would have the following
estimated effects on the 2021 pension benefit obligation, which would be
reflected in the 2021 MTM expense (benefit), and 2022 expected pension expense:
                                                               25 Basis Point           25 Basis Point
$ in millions                                                 Decrease in Rate         Increase in Rate
2021 pension obligation and MTM expense (benefit)             $           -          $             151
2022 pension (benefit) expense                                            -                         10


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 certain Voluntary Employee Beneficiary Association
trusts are taxable.
During 2021, the Investment Committee of the company's benefit plans reviewed
and approved the plans' major asset class allocations. The current asset
allocation is approximately 40% public equities, 30% fixed-income, 25%
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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 2021
was approximately 11.2 percent and our 20-year and 30-year rolling average rates
of return were approximately 8.8 percent and 9.6 percent, respectively, each
determined on an arithmetic basis and net of expenses. Our 2021 actual net plan
asset returns were approximately 10.9 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.
For determining 2021 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 7.22 percent. For 2022 FAS expense, we have assumed
an expected long-term rate of return on pension plan assets of 7.5 percent and
7.19 percent on OPB plans. Holding all other assumptions constant, an increase
or decrease of 25 basis points in our December 31, 2021 EROA assumption would
have the following estimated effects on 2022 expected pension and OPB expense:
                                                               25 Basis Point            25 Basis Point
$ in millions                                                     Decrease                  Increase
2022 pension and OPB expense (benefit)                       $             92          $           (92)


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 2022 MTM expense (benefit):
  $ in millions                  100 Basis Point Decrease       100 Basis Point Increase
  2022 MTM expense (benefit)    $                     369      $                   (369)


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. In October 2014, the Society of Actuaries Retirement Plans
Experience Committee (RPEC) issued updated mortality tables and a mortality
improvement scale, which reflected longer life expectancies than previously
projected. In October 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. In October 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.
After considering the information released by the RPEC in October 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. Accordingly, we updated the mortality assumptions
used in calculating our pension and OPB obligations recognized at December 31,
2021, and the amounts estimated for our 2022 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
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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, our U.S. government
contract mix and past practices. Portions of the company's environmental
liabilities we do not expect to be recoverable have been expensed.
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. Judgment is exercised by the company in determining the level of evidence
necessary and appropriate to support its 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. Our 2021 increase in unrecognized tax benefits of $149 million
was primarily related to our methods of accounting associated with the timing of
revenue recognition and related costs and the 2017 Tax Cuts and Jobs Act, which
includes related final revenue recognition regulations issued in December 2020
under IRC Section 451(b) and procedural guidance issued in August 2021.
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 Other Purchased Intangible 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.
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 of December 31, 2021 and 2020, respectively,
indicated that the estimated fair value of each reporting unit exceeded its
respective carrying value. There were no impairment charges recorded in the
years ended December 31, 2021, 2020 and 2019.
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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 2021, we considered
COVID-19-related impacts on our business and 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 corroborate the fair values of our reporting units
determined under the market valuation method of the income approach.
We test for impairment of our 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 ended December 31, 2021, 2020 and 2019.
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.
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NORTHROP GRUMMAN CORPORATION

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