NORTHROP GRUMMAN CORPORATION OVERVIEW
The following discussion should be read along with the financial statements included in this Form 10-K, as well as Part II, "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of our Form 10-K for the year endedDecember 31, 2020 ("2020 Annual Report on Form 10-K"). Disposition of IT and Mission Support Services Business EffectiveJanuary 30, 2021 (the "Divestiture date"), we completed the sale of our IT and mission support services business (the "IT services divestiture") for$3.4 billion in cash and recorded a pre-tax gain of$2.0 billion . The IT and mission support services business was comprised of the majority of the former IS&S division of Defense Systems (excluding theVinnell Arabia business); select cyber, intelligence and missions support programs, which were part of the former CIMS division of Mission Systems; and the former Space Technical Services business unit of Space Systems. Operating results include sales and operating income for the IT and mission support services business prior to the Divestiture date. See Note 2 to the consolidated financial statements for further information regarding the disposition. COVID-19 COVID-19 was first reported in late 2019. InMarch 2020 , theWorld 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 endedDecember 31, 2020 , and subsequentSEC 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 theCenters 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 theU.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 theU.S. , theFood 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. InSeptember 2021 , theWhite House issued an executive order and guidance from theSafer Federal Workforce Task Force broadly requiring manyU.S. -based federal contractors to be fully vaccinated byDecember 8, 2021 (or to have an approved accommodation). In earlyNovember 2021 , the federal government extended that deadline toJanuary 18, 2022 . OnDecember 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 -31- --------------------------------------------------------------------------------
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 theDoD 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 TheU.S. and its allies continue to face a global security environment of heightened tensions and instability, threats from state and non-state actors, including 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 ofBritain's exit from theEuropean 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 OnMay 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 inCongress . The Administration's budget request included funding for an infrastructure and economic recovery plan and an education and economic support plan. OnNovember 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 toU.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. OnSeptember 30, 2021 , a continuing resolution was enacted, providing funding generally at FY 2021 levels throughDecember 3, 2021 ; the continuing resolution was further extended throughFebruary 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. -32- --------------------------------------------------------------------------------
The Bipartisan Budget Act of 2019 suspended the debt ceiling throughJuly 31, 2021 . InOctober 2021 , the statutory debt limit was increased by$480 billion and, inDecember 2021 , was further increased by$2.5 trillion , which is currently expected to allow theTreasury 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 ourU.S. government business, most types of costs are allocable toU.S. government contracts. As such, we do not focus on individual cost groupings (such as manufacturing, engineering and design labor, subcontractor, material, overhead and general and administrative (G&A) costs), as much as we do on total contract cost, which is the key driver of our sales and operating income. In evaluating our operating performance, we primarily focus on changes in sales and operating margin rates. Where applicable, significant fluctuations in operating performance attributable to individual contracts or programs, or changes in a specific cost element across multiple contracts, are described in our analysis. Based on this approach and the nature of our operations, the discussion of results of operations below first focuses on our four segments before distinguishing between products and services. Changes in sales are generally described in terms of volume, while changes in operating margin rates are generally described in terms of performance and/or contract mix. For purposes of this discussion, volume generally refers to increases or decreases in sales or cost from production/service activity levels and performance generally refers to non-volume related changes in profitability. 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 inthe United States of America ("GAAP" or "FAS"). Organic sales is defined as total sales excluding sales attributable to the company's IT services divestiture. This measure may be useful to investors and other users of our financial statements as a supplemental measure in evaluating the company's underlying sales growth as well as in providing an understanding of our ongoing business and future sales trends by presenting the company's sales before the impact of divestiture activity. Transaction-adjusted net earnings and transaction-adjusted earnings per share (transaction-adjusted EPS) exclude impacts related to the IT services divestiture, including the gain on sale of the business, associated federal and state income tax expenses, transaction costs, and the make-whole premium for early debt redemption. They also exclude the impact of mark-to-market pension and OPB ("MTM") benefit/(expense) and related tax impacts, which are generally only recognized during the fourth quarter. These non-GAAP measures may be useful to investors and other users of our financial statements as supplemental measures in evaluating the company's underlying financial performance by presenting the company's operating results before the non-operational impact of divestiture activity and pension and OPB actuarial gains and losses. These measures are also consistent with how management views the underlying performance of the business as the impact of the IT services divestiture and MTM accounting are not considered in management's assessment of the company's operating performance or in its determination of incentive compensation awards. We reconcile these non-GAAP financial measures to their most directly comparable GAAP financial measures below. These non-GAAP measures may not be defined and calculated by other companies in the same manner and should not be considered in isolation or as an alternative to operating results presented in accordance with GAAP. -33- --------------------------------------------------------------------------------
Selected 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 sales 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 %
SalesThe 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. -35- --------------------------------------------------------------------------------
NORTHROP GRUMMAN CORPORATION 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$160 million , or 4 percent, primarily due to lower unallocated corporate expense and higher segment operating income, partially offset by higher income tax expense. -36- --------------------------------------------------------------------------------
NORTHROP GRUMMAN CORPORATION Diluted Earnings Per Share The table below reconciles diluted earnings per share to transaction-adjusted EPS: Year Ended December 31 % Change in 2021 2020 2019 2021 2020 Diluted earnings per share$ 43.54 $ 19.03 $ 13.22 129 % 44 % MTM (benefit) expense per share (14.64) 6.17 10.59 (337) % (42) %
MTM-related deferred state tax expense (benefit) per share(1)
0.77 (0.32) (0.48) (341) % (33) %
Federal tax expense (benefit) of items above 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 ofDecember 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 inJune 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. -38- --------------------------------------------------------------------------------
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 presented 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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--------------------------------------------------------------------------------NORTHROP GRUMMAN CORPORATION 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. -40- --------------------------------------------------------------------------------
NORTHROP GRUMMAN CORPORATION PRODUCT AND SERVICE ANALYSIS The following table presents product and service sales and operating costs and expenses by segment: Year Ended December 31 $ in millions 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 615Total 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 theLake 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 -41- --------------------------------------------------------------------------------
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 atDecember 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 forNASA'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 ofDecember 31, 2021 , we had cash and cash equivalents of$3.5 billion ;$295 million was held outside of theU.S. by foreign subsidiaries. We expect cash and cash equivalents and cash generated from operating activities, supplemented by borrowings under credit facilities, commercial paper and/or in the capital markets through our shelf registration with theSEC , if needed, to be sufficient to provide liquidity to the company in the short-term and long-term. The company has a five-year senior unsecured credit facility in an aggregate principal amount of$2.0 billion , and inApril 2021 , we renewed our one-year$500 million uncommitted credit facility. AtDecember 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. AtDecember 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 underU.S. government contracts. In most circumstances, our risk associated with the purchase obligations on ourU.S. government contracts is limited to the termination liability provisions within those contracts. As such, we do not believe they represent a material liquidity risk to the company. AtDecember 31, 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 allowU.S. companies to defer the employer's portion of social security taxes betweenMarch 27, 2020 andDecember 31, 2020 and pay such taxes in two installments in 2021 and 2022. Our first installment of deferred social security taxes of$200 million was paid in the fourth quarter of 2021 and the second installment of$200 million 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 -42- --------------------------------------------------------------------------------
3610 of the CARES Act and through our contract provisions, though it is unclear what funds will be available and how much we will be able to recover. In addition, theDoD has, 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 theDoD 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 provided by operating activities
(1)Includes depreciation and amortization, non-cash lease expense, MTM benefit (expense), stock based compensation expense, deferred income taxes and net periodic pension and OPB income. 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 inDoD 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 inDoD progress payment rates. -43- --------------------------------------------------------------------------------
NORTHROP GRUMMAN CORPORATION 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 -44- --------------------------------------------------------------------------------
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 atDecember 31, 2021 and 2.68 percent atDecember 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 theDecember 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 ofDecember 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 theDecember 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 certainVoluntary 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% -45- --------------------------------------------------------------------------------
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 ourDecember 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. InOctober 2014 , theSociety of Actuaries Retirement Plans Experience Committee (RPEC) issued updated mortality tables and a mortality improvement scale, which reflected longer life expectancies than previously projected. InOctober 2019 , the RPEC issued an updated mortality base table (the Private Retirement Plans Mortality table for 2012 (Pri-2012)), which we adopted after reviewing our own historical mortality experience. InOctober 2021 , the RPEC released a new projection scale (MP-2021) that included additional underlying data for 2019, which included an increase in life expectancies relative to the prior year. After considering the information released by the RPEC inOctober 2021 as well as the company's recent mortality experience in light of the COVID-19 pandemic, we adopted the full MP-2021 projection scale while continuing to use the Pri-2012 White Collar table. Accordingly, we updated the mortality assumptions used in calculating our pension and OPB obligations recognized atDecember 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 -46- --------------------------------------------------------------------------------
likely to occur; they do not necessarily reflect what management believes should occur. The ultimate resolution of any such exposure to us may vary materially from earlier estimates as further facts and circumstances develop or become known to us. Environmental Matters - We are subject to environmental laws and regulations in the jurisdictions in which we do or have done business. Factors that could result in changes to the assessment of probability, range of reasonably estimated costs and environmental accruals include: modification of planned remedial actions; changes in the estimated time required to conduct remedial actions; discovery of more or less extensive (or different) contamination than anticipated; information regarding the potential causes and effects of contamination; results of efforts to involve other responsible parties; financial capabilities of other responsible parties; changes in laws and regulations, their interpretation or application; contractual obligations affecting remediation or responsibilities; and improvements in remediation technology. As we expect to be able to recover a portion of environmental remediation liabilities through overhead charges on government contracts, such amounts are deferred in prepaid expenses and other current assets (current portion) and other non-current assets until charged to contracts. We use judgment to evaluate the recoverability of our environmental remediation costs, assessing, among other things,U.S. government regulations, ourU.S. government contract mix and past practices. Portions of the company's environmental liabilities we do not expect to be recoverable have been expensed. 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 inDecember 2020 under IRC Section 451(b) and procedural guidance issued inAugust 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 ofDecember 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 endedDecember 31, 2021 , 2020 and 2019. -47- --------------------------------------------------------------------------------
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 endedDecember 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. -48- --------------------------------------------------------------------------------
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