Buoyed by the acquisition of Orbital ATK, a positive cost claim, improved segment margins, a pension benefit and lower taxes, Northrop Grumman [NOC] on Wednesday reported higher sales and earnings in its third quarter.

The company also raised its earnings and cash flow guidance for 2018 to reflect the cost claim, lower interest expense, a pension benefit and lower than expected taxes.

Net income soared 78 percent to $1.1 billion, $6.54 earnings per share (EPS), from $643 million ($3.67 EPS) a year ago. Operating income at two of the company’s three legacy segments, Aerospace Systems and Mission Systems, was higher due to increased sales and improved performance, more than offsetting a decline at Technology Services due to lower sales.

Kathy Warden, president and chief operating officer of Northrop Grumman. Photo: Northrop Grumman
Kathy Warden, president and chief operating officer of Northrop Grumman. Warden will become CEO on Jan. 1. Photo: Northrop Grumman

Innovation Systems, a new segment created over the summer to organize Orbital ATK, added $161 million in operating income.

There were a number of puts and takes to the bottom line, including higher segment operating income, a favorable $223 million pre-tax cost claim, lower taxes, and a handsome pension tailwind, while on the downside were $97 million in pre-tax merger expenses, $60 million more in interest expense, and $32 million in deferred state taxes and legal expenses.

At the operating level, Innovation Systems contributed $161 million in income versus nothing a year ago when Orbital ATK was still a separate company, and both the Aerospace Systems and Mission Systems segments also reported strong earnings due to higher sales and improved performance. Segment operating margin jumped 60 basis points to 12.1 percent.

Sales were up 23 percent to $8.1 billion versus $6.6 billion a year ago, with Innovation Systems accounting for most of the increase, $1.4 billion, while Aerospace and Mission Systems were up modestly.

The Technology Services segment posted lower sales and income and the company plans to consolidate the business beginning in 2019 to go from three divisions to two. To “maximize operational efficiency and continue to posture for growth,” the Advanced Defense Services, and Systems Modernization and Services business within Technology Services will be combined, Kathy Warden, Northrop Grumman’s president and chief operating officer, said on Wednesday’s investor call.  She said later in the call that the restructuring will help with “innovation and affordability” at the segment.

Warden is overseeing the integration of Innovation Systems and will become president and CEO on Jan. 1. The integration of Innovation Systems is “on track to meet or exceed our cost reduction targets,” she said.

Sanford Bernstein analyst Doug Harned on the earnings call suggested that with the integration of Innovation Systems, to get the revenue synergies that Northrop Grumman believes the deal offers it will have to include organizational changes to better align the various businesses. Warden said her “primary focus” next year will be reviewing the portfolio and sort out how to best organize the company to pursue the revenue synergies.

Warden said that operating as a standalone sector next year will allow Northrop Grumman to achieve the cost synergies targeted for Innovation Systems and to cross-share the best operating models between the two companies.

Northrop Grumman maintained its sales target for 2018 at around $30 billion and increased its earnings guidance by $2.15 cents per share to between $18.75 and $19 due to strong performance so far this year, as well as a lower than expected tax rate and interest expense.

Backlog at the end of the quarter stood at $52.6 billion, up $400 million from the end of the second quarter. Free cash flow was $530 million and for the year is expected to be between $2.5 billion and $2.7 billion, $100 million above prior guidance.