Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

OVERVIEW

As previously announced, effective January 1, 2018, we adopted ASC Topic 606, Revenue from Contracts with Customers, and ASU No. 2017-07, Compensation Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, using the full retrospective method.

Additionally, during the fourth quarter of 2018, we changed our GAAP accounting method related to the recognition of actuarial gains and losses for the company’s pension and other postretirement benefit (OPB) plans (the “Accounting change”). Prior to the Accounting change, actuarial gains and losses were recognized as a component of Accumulated other comprehensive (loss) income upon annual remeasurement and were amortized into earnings in future periods on a plan-by-plan basis when they exceeded the accounting corridor, a defined range within which amortization of net gains and losses is not required. Under the new method, actuarial gains and losses are immediately recognized in net periodic benefit cost through Mark-to-market pension and OPB (“MTM”) (expense) benefit upon annual remeasurement in the fourth quarter, or on an interim basis as triggering events warrant remeasurement.

Our 2017 and 2016 results below have been recast to reflect the impact of the adoption of ASC Topic 606 and ASU 2017-07 and the Accounting change as described in Notes 1, 13, 16, 17 and 18 to the consolidated financial statements.

Acquisition of Orbital ATK

On June 6, 2018 (the “Merger Date”), the company completed its previously announced acquisition of Orbital ATK, Inc. (“Orbital ATK”) (the “Merger”), by acquiring all of the outstanding shares of Orbital ATK for a purchase price of $7.7 billion in cash. On the Merger date, Orbital ATK became a wholly-owned subsidiary of the company and its name was changed to Northrop Grumman Innovation Systems, Inc. We established Innovation Systems as a new, fourth business sector, whose main products include launch vehicles and related propulsion systems; missile products and defense electronics; precision weapons, armament systems and ammunition; satellites and associated space components and services; and advanced aerospace structures. The acquisition was financed with proceeds from the company’s debt financing completed in October 2017 and cash on hand. We believe this acquisition will enable us to broaden our capabilities and offerings, provide additional innovative solutions to meet our customers’ emerging requirements, create value for shareholders and provide expanded opportunities for our combined employees. See Note 2 to the consolidated financial statements for further information regarding the acquisition of Orbital ATK.

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 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 2019, reflecting the impact of and uncertainty surrounding geopolitical tensions globally and financial market volatility. The global economy may also be affected by Britain’s anticipated exit from the European Union, the full impact of which is not known at this time. 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

The U.S. continues to face an uncertain political environment and substantial fiscal and economic challenges, which affect funding for discretionary and non-discretionary budgets. The Budget Control Act of 2011 (BCA) mandated spending caps for all federal discretionary spending across a ten-year period (FY 2012 through FY 2021), including specific limits for defense and non-defense spending. In prior years, these spending caps have been revised by separate bills for specific fiscal years.

Most recently, on February 9, 2018, Congress passed the Bipartisan Budget Act (BBA) of 2018, which raised the statutory budget caps for defense spending, including for Overseas Contingency Operations (OCO), by $80 billion for FY 2018 and by $85 billion for FY 2019. The BBA also raised non-defense spending by $63 billion for FY 2018 and $68 billion for FY 2019 and suspended the debt ceiling until March 1, 2019. The original spending caps

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established by the BCA will return for FY 2020 and FY 2021 without another statutory change. Similarly, the suspension of the debt ceiling is expected to end on March 1, 2019 absent further action.

On March 23, 2018, the President signed the Omnibus Appropriations Act for FY 2018, which provided $1.3 trillion in discretionary funding for federal agencies. In total for FY 2018, Congress appropriated approximately $700 billion for national security, including approximately $630 billion for base discretionary funding and approximately $70 billion in OCO funding.

On September 28, 2018, full-year appropriations for FY 2019 were enacted representing over half of discretionary federal spending. For FY 2019, Congress appropriated approximately $716 billion for national security, including approximately $647 billion for base discretionary funding and approximately $69 billion in OCO funding. A continuing resolution was approved to provide further funding for other agencies (including NASA and other civil agencies) through December 7, 2018, which was subsequently extended through December 21, 2018. On December 22, 2018, U.S. government agencies that had not yet received full-year appropriations and did not otherwise have funding entered into a temporary shutdown. On January 25, 2019, a third continuing resolution was enacted, which funds these agencies through February 15, 2019.

The federal budget and debt ceiling are expected to continue to be the subject of considerable debate, which could have significant 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 Federal Acquisition Regulation (FAR) rules that govern our U.S. government business and related Cost Accounting Standards (CAS), 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 look primarily at changes in sales and operating income. 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 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 lifecycle (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 financial and operating performance using certain financial measures that are not calculated in accordance with GAAP. These non-GAAP financial measures exclude MTM (expense) benefit and related tax impacts, and are described as MTM-adjusted net earnings and MTM-adjusted diluted earnings per share. 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 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 MTM accounting is 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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Selected financial highlights are presented in the table below:

	Year Ended December 31												% Change in
$ in millions, except per share amounts	2018				2017				2016				2018			2017
Sales	$	30,095			$	26,004			$	24,706			16	%		5	%
Operating costs and expenses	26,315				22,786				21,429				15	%		6	%
Operating costs and expenses as a % of sales	87.4		%		87.6		%		86.7		%
Operating income	3,780				3,218				3,277				17	%		(2	)%
Operating margin rate	12.6		%		12.4		%		13.3		%
Mark-to-market pension and OPB (expense) benefit	(655		)		536				(950		)		NM			NM
Federal and foreign income tax expense	513				1,360				638				(62	)%		113	%
Effective income tax rate	13.7		%		32.2		%		23.8		%
Net earnings	3,229				2,869				2,043				13	%		40	%
Diluted earnings per share	18.49				16.34				11.32				13	%		44	%

Sales

2018 – Sales increased $4.1 billion, or 16 percent, as compared with 2017, due to the addition of $3.3 billion of sales from Innovation Systems and higher sales at Aerospace Systems and Mission Systems, partially offset by lower sales at Technology Services.

2017 – Sales increased $1.3 billion, or 5 percent, as compared with 2016, primarily due to higher sales at Aerospace Systems and Mission Systems.

See “Segment Operating Results” below for further information by segment and “Product and Service Analysis” for product and service detail. See Note 15 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.

Operating Income and Margin Rate

2018 – Operating income increased $562 million, or 17 percent, as compared with 2017, primarily due to a $544 million increase in segment operating income, which includes the addition of $343 million of operating income from Innovation Systems, and a $42 million decrease in unallocated corporate expense, partially offset by a $25 million decrease in our net FAS (service)/CAS pension adjustment, all of which are further discussed in “Segment Operating Results.” Lower operating costs and expenses as a percentage of sales increased our operating margin rate to 12.6 percent from 12.4 percent in the prior year period and was principally driven by a higher segment operating margin rate, as described in “Segment Operating Results,” and the previously noted decrease in unallocated corporate expense, partially offset by the decrease in our net FAS (service)/CAS pension adjustment.

G&A as a percentage of sales decreased to 10.0 percent in 2018 from 10.4 percent in 2017, principally due to higher sales volume.

2017 – Operating income for 2017 decreased $59 million, or 2 percent, as compared with 2016, primarily due to a $280 million increase in unallocated corporate expense, partially offset by a $181 million increase in our net FAS (service)/CAS pension adjustment and a $39 million increase in segment operating income, all of which are further discussed in “Segment Operating Results.” Higher operating costs and expenses as a percentage of sales reduced our operating margin rate to 12.4 percent from 13.3 percent in the prior year period and principally was driven by the previously noted increase in unallocated corporate expense and a lower segment operating margin rate, as described in “Segment Operating Results,” partially offset by the increase in our net FAS (service)/CAS pension adjustment.

G&A as a percentage of sales decreased to 10.4 percent in 2017 from 10.7 percent in 2016, principally due to higher sales volume.

For further information regarding product and service operating costs and expenses, see “Product and Service Analysis” below.

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Mark-to-Market Pension and OPB Adjustment

The primary components of pre-tax MTM (expense) benefit are presented in the table below:

	Year Ended December 31
$ in millions	2018				2017				2016
Actuarial gains (losses) on projected benefit obligation	$	2,772			$	(1,570	)		$	(988	)
Actuarial (losses) gains on plan assets	(3,426		)		2,119				25
Other	(1		)		(13		)		13
MTM (expense) benefit	$	(655	)		$	536			$	(950	)

2018 – MTM expense of $655 million in 2018 was primarily driven by actual net plan asset losses of approximately 3.5 percent, partially offset by actuarial gains principally resulting from a 63 basis point increase in the discount rate. In 2017, we recognized a MTM benefit of $536 million as described below.

2017 – MTM benefit of $536 million in 2017 was primarily driven by actual net plan asset returns of approximately 16.4 percent, partially offset by actuarial losses principally resulting from a 51 basis point decrease in the discount rate. MTM expense of $950 million in 2016 was primarily driven by actuarial losses largely resulting from a 34 basis point decrease in the discount rate.

Federal and Foreign Income Taxes

2018 – Our effective tax rate for 2018 was lower than 2017 primarily due to the Tax Cuts and Jobs Act (the “2017 Tax Act”), as discussed in Note 7 to the consolidated financial statements.

2017 – Our effective tax rate for 2017 was higher than 2016 primarily due to the 2017 Tax Act, as discussed in Note 7 to the consolidated financial statements.

Net Earnings

The table below reconciles net earnings to MTM-adjusted net earnings:

	Year Ended December 31												% Change in
$ in millions	2018				2017				2016				2018			2017
Net earnings	$	3,229			$	2,869			$	2,043			13	%		40	%
MTM expense (benefit)	655				(536		)		950				NM			NM
MTM-related deferred state tax (benefit) expense(1)	(29		)		24				(43		)		NM			NM
Federal tax (benefit) expense of items above(2)	(131		)		108				(317		)		NM			NM
MTM adjustment, net of tax	495				(404		)		590				NM			NM
MTM-adjusted net earnings	$	3,724			$	2,465			$	2,633			51	%		(6	)%

(1)	Deferred state taxes are recorded in unallocated corporate expense within operating income.

(2)	Based on a 21% federal statutory tax rate for the years ended December 31, 2018 and 2017 and a 35% federal statutory tax rate for the year ended December 31, 2016.

2018 – Net earnings for 2018 increased $360 million, or 13 percent, as compared with 2017, and includes an $899 million reduction related to impacts associated with our MTM adjustment, net of tax. Excluding these impacts, MTM-adjusted net earnings increased by $1.3 billion, or 51 percent, primarily due to the lower effective tax rate described above, $544 million of higher segment operating income, and a $350 million increase in our net FAS (non-service) pension benefit. These increases were partially offset by $202 million of higher interest expense.

2017 – Net earnings for 2017 increased $826 million, or 40 percent, as compared with 2016, and includes a $1 billion increase related to impacts associated with our MTM adjustment, net of tax. Excluding these items, MTM-adjusted net earnings decreased by $168 million, or 6 percent, primarily due to the higher effective tax rate noted above and $59 million of higher interest expense resulting from our debt issuance in October 2017, as described in Note 10 to the consolidated financial statements. These decreases were partially offset by a $92 million increase in Other, net as a result of gains on the sale of two investments and higher interest income on short-term investments as well as an $88 million increase in our net FAS (non-service) pension benefit.

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Diluted Earnings Per Share

The table below reconciles diluted earnings per share to MTM-adjusted diluted earnings per share:

	Year Ended December 31												% Change in
	2018				2017				2016				2018			2017
Diluted earnings per share	$	18.49			$	16.34			$	11.32			13	%		44	%
MTM expense (benefit) per share	3.76				(3.06		)		5.27				NM			NM
MTM-related deferred state tax (benefit) expense per share(1)	(0.17		)		0.14				(0.24		)		NM			NM
Federal tax (benefit) expense of items above per share(2)	(0.75		)		0.62				(1.76		)		NM			NM
MTM adjustment per share, net of tax	2.84				(2.30		)		3.27				NM			NM
MTM-adjusted diluted earnings per share	$	21.33			$	14.04			$	14.59			52	%		(4	)%

(1)	Deferred state taxes are recorded in unallocated corporate expense within operating income.

(2)	Based on a 21% federal statutory tax rate for the years ended December 31, 2018 and 2017 and a 35% federal statutory tax rate for the year ended December 31, 2016.

2018 – Diluted earnings per share for 2018 increased $2.15, or 13 percent, as compared with 2017, and includes a $5.14 reduction related to impacts associated with our MTM adjustment, net of tax. Excluding these impacts, MTM-adjusted diluted earnings per share increased $7.29, or 52 percent, primarily due to the 51 percent increase in MTM-adjusted net earnings discussed above.

2017 – Diluted earnings per share for 2017 increased $5.02, or 44 percent, as compared with 2016, and includes a $5.57 increase related to impacts associated with our MTM adjustment, net of tax. Excluding these items, MTM-adjusted diluted earnings per share decreased $0.55, or 4 percent, primarily due to the 6 percent decline in MTM-adjusted net earnings discussed above, partially offset by a 3 percent reduction in weighted-average shares outstanding resulting principally from shares repurchased during 2016.

SEGMENT OPERATING RESULTS

Basis of Presentation

The company is aligned in four operating sectors, which also comprise our reportable segments: Aerospace Systems, Innovation Systems, Mission Systems and Technology Services. As described above, on the effective date of the Merger, we established Innovation Systems as a new, fourth business sector. The segment operating results below include sales and operating income for Innovation Systems subsequent to the Merger date. 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:

Aerospace Systems		Innovation Systems		Mission Systems		Technology Services
Autonomous Systems		Defense Systems		Advanced Capabilities		Advanced Defense Services
Manned Aircraft		Flight Systems		Cyber and ISR		Global Logistics and Modernization
Space		Space Systems		Sensors and Processing		System Modernization and Services

This section discusses segment sales, operating income and operating margin rates. A reconciliation of segment operating income to total operating income is provided below.

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Segment Operating Income and Margin Rate

Segment operating income, as reconciled in the Reconciliation of Segment Operating Income to Total Operating Income section below, is a non-GAAP measure that reflects total earnings from our four segments, including allocated pension expense recognized under CAS, and excluding unallocated corporate items and FAS pension expense. This non-GAAP measure may be useful to investors and other users of our financial statements as a supplemental measure in evaluating the financial performance and operational trends of our sectors. This non-GAAP measure 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.

	Year Ended December 31												% Change in
$ in millions	2018				2017				2016				2018			2017
Segment operating income	$	3,447			$	2,903			$	2,864			19	%		1	%
Segment operating margin rate	11.5		%		11.2		%		11.6		%

2018 – Segment operating income for 2018 increased $544 million, or 19 percent, as compared with 2017, and includes the addition of $343 million of operating income from Innovation Systems and higher operating income at Aerospace Systems and Mission Systems. The higher operating income includes $69 million of favorable EAC adjustments on multiple restricted programs at Aerospace Systems. Segment operating margin rate increased to 11.5 percent from 11.2 percent in 2017 principally due to higher segment margin rates at each of the legacy Northrop Grumman sectors.

2017 – Segment operating income for 2017 increased $39 million, or 1 percent, as compared with 2016, primarily due to higher operating income at Aerospace Systems, partially offset by lower operating income at Mission Systems and Technology Services. The higher operating income includes a $56 million favorable EAC adjustment at Aerospace Systems on a restricted program largely related to performance incentives and $54 million recognized in connection with a claim related to certain costs incurred in prior years (the “2017 Cost Claim”). Segment operating margin rate decreased to 11.2 percent from 11.6 percent in 2016 principally due to lower segment margin rates at Mission Systems and Aerospace Systems.

Reconciliation of Segment Operating Income to Total Operating Income - The table below reconciles segment operating income to total operating income by including the impact of the net FAS (service)/CAS pension adjustment, as well as unallocated corporate expenses (certain corporate-level expenses, which are not considered allowable or allocable under applicable CAS or FAR, and costs not considered part of management’s evaluation of segment operating performance). See Note 15 to the consolidated financial statements for further information on the net FAS (service)/CAS pension adjustment and unallocated corporate expense.

	Year Ended December 31												% Change in
$ in millions	2018				2017				2016				2018			2017
Segment operating income	$	3,447			$	2,903			$	2,864			19	%		1	%
CAS pension expense	1,017				1,026				847				(1	)%		21	%
Less: FAS (service) pension expense	(404		)		(388		)		(390		)		4	%		(1	)%
Net FAS (service)/CAS pension adjustment	613				638				457				(4	)%		40	%
Intangible asset amortization and PP&E step-up depreciation(1)	(220		)		—				—				NM			NM
MTM-related deferred state tax benefit (expense)(2)	29				(24		)		43				NM			NM
Other unallocated corporate expense(3)	(86		)		(295		)		(82		)		(71	)%		260	%
Unallocated corporate expense	(277		)		(319		)		(39		)		(13	)%		718	%
Other	(3		)		(4		)		(5		)		(25	)%		(20	)%
Total operating income	$	3,780			$	3,218			$	3,277			17	%		(2	)%

(1)	Includes amortization of purchased intangible assets and the additional depreciation expense related to the step-up in fair value of property, plant and equipment (PP&E) acquired through business combinations, which are included in unallocated corporate expense as they are not considered part of management’s evaluation of segment operating performance.

(2)	Represents the deferred state tax impact of MTM (expense) benefit, which is recorded in unallocated corporate expense consistent with other changes in deferred state taxes.

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(3)	Includes $24 million, $34 million and $35 million of deferred state tax expense for the years ended December 31, 2018, 2017 and 2016, respectively, resulting from the reversal of previously recognized amortization of net actuarial losses in connection with the Accounting change.

Net FAS (service)/CAS Pension Adjustment

2018 – The decrease in our net FAS (service)/CAS pension adjustment, as compared with 2017, is primarily due to lower CAS expense for legacy Northrop Grumman resulting from higher assets returns in 2017 and a change in the legacy Northrop Grumman mortality assumption as of December 31, 2017, which more than offset the additional net FAS (service)/CAS pension adjustment from the addition of Innovation Systems.

2017 – The increase in our net FAS (service)/CAS pension adjustment, as compared with 2016, is primarily due to higher CAS expense resulting from the continued phase-in of CAS harmonization and the impact of actual demographic experience, partially offset by a change in our mortality assumption as of December 31, 2016.

Unallocated Corporate Expense

2018 – Unallocated corporate expense for 2018 decreased $42 million, as compared with 2017, primarily due to a $223 million benefit recognized for the finalization of certain prior year corporate cost claims resulting in a reduction of overhead reserves and an increase in our estimated recovery of certain environmental remediation costs and a $53 million increase in MTM-related deferred state tax benefit, partially offset by $220 million of intangible asset amortization and PP&E step-up depreciation.

2017 – Unallocated corporate expense for 2017 increased $280 million, as compared with 2016, primarily due to a $67 million increase in MTM-related deferred state tax expense, $47 million of costs associated with the Orbital ATK acquisition and $41 million of deferred state tax expense resulting from state tax adjustments associated with the filing of our prior year federal tax return and the company's $500 million discretionary pension contribution in December 2017. In addition, the prior year period included a $35 million benefit recognized for state tax refunds claimed on our prior year tax returns and a $25 million benefit recognized for estimated prior year overhead claim recoveries.

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	2018				2017				2016
Favorable EAC adjustments	$	1,019			$	717			$	771
Unfavorable EAC adjustments	(442		)		(357		)		(328		)
Net EAC adjustments	$	577			$	360			$	443

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

	Year Ended December 31
$ in millions	2018				2017				2016
Aerospace Systems	$	309			$	250			$	208
Innovation Systems(1)	34				—				—
Mission Systems	175				104				217
Technology Services	76				19				47
Eliminations	(17		)		(13		)		(29		)
Net EAC adjustments	$	577			$	360			$	443

(1)	Amounts reflect EAC adjustments after the percent complete on Innovation Systems contracts was reset to zero as of the Merger date.

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.

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AEROSPACE SYSTEMS

	Year Ended December 31												% Change in
$ in millions	2018				2017				2016				2018			2017
Sales	$	13,096			$	12,131			$	10,853			8	%		12	%
Operating income	1,411				1,289				1,198				9	%		8	%
Operating margin rate	10.8		%		10.6		%		11.0		%

2018 – Aerospace Systems sales for 2018 increased $965 million, or 8 percent, as compared with 2017, due to higher volume in each of our three business areas, principally on Manned Aircraft programs. Manned Aircraft sales were driven by higher restricted and F-35 volume. Autonomous Systems sales reflect higher volume on several programs, including Triton, partially offset by lower Global Hawk volume. Space sales reflect higher restricted and Ground Based Strategic Deterrent Technology Maturation Risk Reduction volume, partially offset by lower intercompany and James Webb Space Telescope (JWST) volume.

Operating income for 2018 increased $122 million, or 9 percent, primarily due to higher sales and a higher operating margin rate. Operating margin rate increased to 10.8 percent from 10.6 percent principally due to improved performance, including the previously noted $69 million of favorable EAC adjustments on multiple restricted programs in 2018, partially offset by the $56 million favorable EAC adjustment recorded in 2017.

2017 – Aerospace Systems sales for 2017 increased $1.3 billion, or 12 percent, as compared with 2016, primarily due to higher volume on Manned Aircraft programs. Manned Aircraft sales were driven by higher restricted sales. Autonomous Systems sales increased principally due to higher volume for several programs, including Triton, partially offset by lower NATO Alliance Ground Surveillance (AGS) volume. Space sales increased primarily due to higher restricted sales, partially offset by lower volume on the JWST and Advanced Extremely High Frequency (AEHF) programs.

Operating income for 2017 increased $91 million, or 8 percent, primarily due to higher sales, partially offset by a lower operating margin rate. Operating margin rate decreased to 10.6 percent from 11.0 percent principally due to changes in contract mix on Manned Aircraft programs and a gain of $45 million recognized in the prior year associated with the sale of a property, partially offset by the previously discussed $56 million favorable EAC adjustment largely related to performance incentives.

INNOVATION SYSTEMS

	Year Ended December 31										% Change in
$ in millions	2018				2017			2016			2018		2017
Sales	$	3,276			—			—			—		—
Operating income	343				—			—			—		—
Operating margin rate	10.5		%		—			—

The sales and operating income above reflect the operating results of Innovation Systems subsequent to the Merger date. In our comparative discussion below, we reference pro forma sales prepared in accordance with Article 11 of Regulation S-X and computed as if the Merger had been completed as of January 1, 2017. Refer to Note 2 to the consolidated financial statements for additional supplemental consolidated pro forma financial information. This pro forma financial information should not be considered indicative of the results that would have actually occurred if the Merger had been consummated on January 1, 2017, nor are they indicative of future results.

2018 – Innovation Systems sales for 2018 were $5.6 billion and for 2017 were $4.8 billion, each on a pro forma basis. The $0.8 billion, or 17 percent, increase reflects higher volume in each business area. Defense Systems sales reflect increased international volume on armament systems programs and increased volume on the Anti-Radiation Guided Missile program and small caliber ammunition programs. Flight Systems sales were primarily driven by higher Ground-based Midcourse Defense, A350 and F-35 volume. Space Systems sales increased primarily due to higher government satellite volume.

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MISSION SYSTEMS

	Year Ended December 31												% Change in
$ in millions	2018				2017				2016				2018			2017
Sales	$	11,709			$	11,470			$	11,161			2	%		3	%
Operating income	1,520				1,442				1,468				5	%		(2	)%
Operating margin rate	13.0		%		12.6		%		13.2		%

2018 – Mission Systems sales for 2018 increased $239 million, or 2 percent, as compared with 2017, primarily due to higher Sensors and Processing volume, partially offset by lower Cyber and ISR and Advanced Capabilities volume. Sensors and Processing sales increased principally due to higher volume on restricted programs, communications programs, F-35 and electro-optical/infrared (EO/IR) self-protection programs. Cyber and ISR sales decreased primarily due to ramp-down on a restricted ISR program. Advanced Capabilities sales reflect lower volume on the Joint National Integration Center Research and Development (JRDC) program and follow on activity, partially offset by higher volume on several programs, including the Integrated Air and Missile Defense Battle Command System program.

Operating income for 2018 increased $78 million, or 5 percent, due to a higher operating margin rate and higher sales. Operating margin rate increased to 13.0 percent from 12.6 percent primarily due to improved performance on Cyber and ISR and Sensors and Processing programs, partially offset by a $32 million benefit recognized in the prior year in connection with the 2017 Cost Claim described above.

2017 – Mission Systems sales for 2017 increased $309 million, or 3 percent, as compared with 2016 primarily due to higher Sensors and Processing volume, partially offset by lower Cyber and ISR volume. Sensors and Processing sales increased principally due to higher volume on F-35 sensors, EO/IR self-protection programs, communications programs and the SABR program. These increases were partially offset by lower volume on international ground-based radar programs. Cyber and ISR sales decreased primarily due to lower volume on restricted ISR programs.

Operating income for 2017 decreased $26 million, or 2 percent, primarily due to a lower operating margin rate, partially offset by higher sales and $32 million recognized in connection with the 2017 Cost Claim described above. Operating margin rate decreased to 12.6 percent from 13.2 percent primarily due to lower margin rates on Sensors and Processing and Cyber and ISR programs principally resulting from lower performance and changes in contract mix. This decrease was partially offset by improved margin rates at Advanced Capabilities primarily due to the prior year including a $49 million forward loss provision on an Advanced Capabilities program.

TECHNOLOGY SERVICES

	Year Ended December 31												% Change in
$ in millions	2018				2017				2016				2018			2017
Sales	$	4,297			$	4,687			$	4,765			(8	)%		(2	)%
Operating income	443				449				456				(1	)%		(2	)%
Operating margin rate	10.3		%		9.6		%		9.6		%

2018 – Technology Services sales for 2018 decreased $390 million, or 8 percent, as compared with 2017, due to lower volume on Advanced Defense Services and System Modernization and Services programs, partially offset by higher volume on Global Logistics and Modernization programs. Advanced Defense Services and System Modernization and Services sales decreased primarily due to the completion of several programs, including JRDC, partially offset by higher volume on the Saudi Arabian Ministry of National Guard Training Support program (through our interest in a joint venture for which we consolidate the financial results). Global Logistics and Modernization sales increased primarily due to higher volume for several programs, including the Special Electronic Mission Aircraft program, partially offset by lower volume from the completion of the KC-10 program.

Operating income for 2018 decreased $6 million, or 1 percent, primarily due to lower sales, partially offset by a higher operating margin rate. Operating margin rate increased to 10.3 percent from 9.6 percent primarily due to the close-out of a state IT outsourcing program.

2017 – Technology Services sales for 2017 decreased $78 million, or 2 percent, as compared with 2016, primarily due to lower volume on System Modernization and Services programs, partially offset by higher volume on Global Logistics and Modernization programs. System Modernization and Services sales decreased principally due to the completion of several programs in 2016 and 2017. Global Logistics and Modernization sales increased primarily due

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to higher intercompany volume and increased sales on the UKAWACS and Hunter programs, partially offset by lower volume on the KC-10 program as our contract nears completion.

Operating income for 2017 decreased $7 million, or 2 percent, primarily due to lower sales as described above. Operating margin rate was comparable to the prior year.

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		2018								2017								2016
Segment Information:		Sales				Operating Costs and Expenses				Sales				Operating Costs and Expenses				Sales				Operating Costs and Expenses
Aerospace Systems
Product		$	11,087			$	9,889			$	10,064			$	8,988			$	8,947			$	7,945
Service		2,009				1,796				2,067				1,854				1,906				1,710
Innovation Systems
Product		2,894				2,582				—				—				—				—
Service		382				351				—				—				—				—
Mission Systems
Product		7,329				6,335				7,012				6,088				6,726				5,810
Service		4,380				3,854				4,458				3,940				4,435				3,883
Technology Services
Product		485				450				391				360				327				299
Service		3,812				3,404				4,296				3,878				4,438				4,010
Segment Totals
Total Product		$	21,795			$	19,256			$	17,467			$	15,436			$	16,000			$	14,054
Total Service		10,583				9,405				10,821				9,672				10,779				9,603
Intersegment eliminations		(2,283		)		(2,013		)		(2,284		)		(2,007		)		(2,073		)		(1,815		)
Total Segment(1)		$	30,095			$	26,648			$	26,004			$	23,101			$	24,706			$	21,842

(1)	A reconciliation of segment operating income to total operating income is included in “Segment Operating Results.”

Product Sales and Costs

2018 – Product sales for 2018 increased $4.3 billion, or 25 percent, as compared with 2017. The increase was primarily due to the addition of $2.9 billion of product sales from Innovation Systems and higher restricted and F-35 volume at Aerospace Systems.

Product costs for 2018 increased $3.8 billion, or 25 percent, as compared with 2017, consistent with the higher product sales described above.

2017 – Product sales for 2017 increased $1.5 billion, or 9 percent, as compared with 2016. The increase was primarily due to higher product sales at Aerospace Systems and Mission Systems. Higher Aerospace Systems product sales were primarily driven by increased restricted volume, partially offset by lower volume on the JWST and NATO AGS programs. The increase at Mission Systems was principally due to higher product volume on F-35 sensors, EO/IR self-protection programs and the SABR program.

Product costs for 2017 increased $1.4 billion, or 10 percent, as compared with 2016, consistent with the higher product sales described above and reflects lower product margin rates at Aerospace Systems, principally due to changes in contract mix, and Mission Systems.

Service Sales and Costs

2018 – Service sales for 2018 decreased $238 million, or 2 percent, as compared with 2017. The decrease was primarily driven by lower service sales at Technology Services principally due to the completion of several programs, partially offset by the addition of $382 million of service sales from Innovation Systems.

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Service costs for 2018 decreased $267 million, or 3 percent, as compared with 2017, consistent with the lower service sales described above and reflects a higher service margin rate at Technology Services due to the close-out of a state IT outsourcing program.

2017 – Service sales for 2017 were comparable with 2016. Higher service sales at Aerospace Systems on several Autonomous Systems and Manned Aircraft programs were offset by lower service volume principally on the KC-10 program at Technology Services.

Service costs for 2017 increased $69 million, or 1 percent, as compared with 2016. The increase principally reflects a lower service margin rate at Mission Systems.

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 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.

As discussed in Note 1 to the consolidated financial statements, we adopted ASC Topic 606 on January 1, 2018 using the full retrospective method and applied the transition practical expedient related to backlog for reporting periods presented before the date of initial application. However, for comparative purposes, we have recast our backlog as of December 31, 2017 to reflect the impact of adoption of ASC Topic 606.

Backlog consisted of the following at December 31, 2018 and 2017:

		2018												2017
$ in millions		Funded				Unfunded				Total Backlog				Total Backlog				% Change in 2018
Aerospace Systems		$	11,448			$	14,992			$	26,440			$	25,560			3	%
Innovation Systems		5,928				2,279				8,207				—				—
Mission Systems		9,676				5,732				15,408				13,277				16	%
Technology Services		2,883				562				3,445				3,792				(9	)%
Total backlog		$	29,935			$	23,565			$	53,500			$	42,629			26	%

Approximately $26.6 billion of the $53.5 billion total backlog at December 31, 2018 is expected to be converted into sales in 2019.

LIQUIDITY AND CAPITAL RESOURCES

We endeavor to ensure the most efficient conversion of operating income into cash for deployment in our business and to maximize shareholder value through cash deployment activities. In addition to our cash position, we use various financial measures to assist in capital deployment decision-making, including cash provided by operating activities and free cash flow, a non-GAAP measure described in more detail below.

As of December 31, 2018, we had cash and cash equivalents of $1.6 billion; approximately $250 million was held outside of the U.S. by foreign subsidiaries. Cash and cash equivalents and cash generated from operating activities, supplemented by borrowings under credit facilities, commercial paper and/or in the capital markets, if needed, are expected to be sufficient to fund our operations for at least the next 12 months. Capital expenditure commitments were $784 million at December 31, 2018, and are expected to be paid with cash on hand.

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Operating Cash Flow

The table below summarizes key components of cash flow provided by operating activities:

		Year Ended December 31
$ in millions		2018				2017				2016
Net earnings		$	3,229			$	2,869			$	2,043
Non-cash items(1)		1,775				1,018				1,439
Changes in assets and liabilities:
Trade working capital		(65		)		(285		)		(169		)
Retiree benefits, excluding MTM (expense) benefit		(1,083		)		(946		)		(375		)
Other, net		(29		)		(43		)		(125		)
Net cash provided by operating activities		$	3,827			$	2,613			$	2,813

(1)	Includes depreciation and amortization, MTM (expense) benefit, stock based compensation expense and deferred income taxes.

2018 – Net cash provided by operating activities for 2018 increased by $1.2 billion, or 46 percent, as compared with 2017, principally due to higher net earnings, which include the addition of Innovation Systems, and improved trade working capital performance.

2017 – Net cash provided by operating activities for 2017 decreased by $200 million, or 7 percent, as compared with 2016, principally due to a $500 million voluntary pre-tax pension contribution ($325 million after-tax) made in December 2017.

Free Cash Flow

Free cash flow, as reconciled in the table below, is a non-GAAP measure defined as net cash provided by operating activities less capital expenditures, and may not be defined and calculated by other companies in the same manner. We use free cash flow as a key factor in our planning for, and consideration of, acquisitions, the payment of dividends and share 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 free cash flow:

		Year Ended December 31												% Change in
$ in millions		2018				2017				2016				2018			2017
Net cash provided by operating activities		$	3,827			$	2,613			$	2,813			46	%		(7	)%
Less: capital expenditures		(1,249		)		(928		)		(920		)		35	%		1	%
Free cash flow		$	2,578			$	1,685			$	1,893			53	%		(11	)%

2018 – Free cash flow for 2018 increased $893 million, or 53 percent, as compared with 2017. The increase was principally driven by the increase in net cash provided by operating activities described above, partially offset by the inclusion of Innovation Systems’ capital expenditures and higher capital expenditures at Aerospace Systems.

2017 – Free cash flow for 2017 decreased $208 million, or 11 percent, as compared with 2016. The decrease was principally driven by the $500 million voluntary pre-tax pension contribution discussed above.

Investing Cash Flow

2018 – Net cash used in investing activities for 2018 increased to $8.9 billion from $889 million in 2017. The increase was principally due to $7.7 billion paid for the acquisition of Orbital ATK, net of cash acquired.

2017 – Net cash used in investing activities for 2017 increased $84 million, or 10 percent, as compared with 2016. The increase was primarily due to proceeds from the 2016 sales of a property at Aerospace Systems and a commercial cyber security business at Mission Systems, partially offset by proceeds from the sale of two investments in 2017.

Financing Cash Flow

2018 – Net cash used in financing activities during 2018 was $4.6 billion, compared to net cash provided by financing activities of $7.0 billion in 2017. The change is principally due to $2.3 billion in debt repayments, $870

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million higher share repurchases and $320 million in payments to credit facilities in 2018, compared with $8.2 billion net proceeds from the issuance of long-term debt in 2017.

2017 – Net cash provided by financing activities during 2017 was $7.0 billion compared to net cash used in financing activities of $1.8 billion in 2016. The change is principally due to $7.5 billion higher net proceeds from the issuance of long-term debt and $1.2 billion lower share repurchases in 2017.

Share Repurchases – See Note 3 to the consolidated financial statements for further information on our share repurchase programs.

Commercial Paper, Credit Facilities and Unsecured Senior Notes – See Note 10 to the consolidated financial statements for further information on our commercial paper, credit facilities and unsecured senior notes.

Financial Arrangements – See Note 12 to the consolidated financial statements for further information on our use of standby letters of credit and guarantees.

Other Sources of Capital – We believe we can obtain additional capital, if necessary for long-term liquidity, from such sources as the public or private capital markets, the sale of assets, sale and leaseback of operating assets, and leasing rather than purchasing new assets. We have an effective shelf registration statement on file with the SEC, which allows us to access capital in a timely manner.

Contractual Obligations

At December 31, 2018, we had contractual commitments to repay debt with interest, make payments under operating leases, settle obligations related to agreements to purchase goods and services and make payments on various other liabilities. Payments due under these obligations and commitments, and the estimated timing of those payments, are as follows:

$ in millions		Total				2019				2020- 2021				2022- 2023				2024 and beyond
Long-term debt		$	14,475			$	517			$	1,868			$	2,558			$	9,532
Interest payments on long-term debt		7,181				550				1,008				903				4,720
Operating leases		2,080				312				491				338				939
Purchase obligations(1)		12,962				7,167				3,862				917				1,016
Other long-term liabilities(2)		1,418				499				376				146				397
Total contractual obligations		$	38,116			$	9,045			$	7,605			$	4,862			$	16,604

(1)

A “purchase obligation” is defined as an agreement to purchase goods or services that is enforceable and legally binding on us and that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. These amounts are primarily comprised of open purchase order commitments to suppliers and subcontractors pertaining to funded contracts.

(2)

Other long-term liabilities, including their current portions, primarily consist of total accrued environmental reserves, deferred compensation and other miscellaneous liabilities, of which $159 million is related to environmental reserves recorded in Other current liabilities. It excludes obligations for uncertain tax positions of $772 million, as the timing of such payments, if any, cannot be reasonably estimated.

The table above excludes estimated minimum funding requirements for the company’s pension and OPB plans, as set forth by the Employee Retirement Income Security Act, as amended. For further information about future minimum contributions for these plans, see Note 13 to the consolidated financial statements. Further details regarding long-term debt and operating leases can be found in Notes 10 and 12, respectively, to the consolidated financial statements.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND JUDGMENTS

Our consolidated financial statements are based on 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.

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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. Changes in estimates of contract sales and cost are frequent. 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. 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 risks affecting contract costs, performance issues with our 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 for our pension and OPB plans and pension and OPB expense 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 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 that is 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 4.31 percent at December 31, 2018, and 3.68 percent at December 31, 2017.

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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, 2018 discount rate assumption would have the following estimated effects on 2018 pension and OPB obligations, which would be reflected in the 2018 MTM expense (benefit), and 2019 expected pension and OPB expense:

$ in millions	25 Basis Point Decrease in Rate				25 Basis Point Increase in Rate
2019 pension and OPB (benefit) expense	$	(22	)		$	20
2018 pension and OPB obligation and MTM expense (benefit)	1,069				(1,016		)

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 tends to move in concert with the discount rate but has an offsetting effect on pension benefit obligations and the related MTM (benefit) expense. The cash balance crediting rate assumption has therefore been set to its current level of 3.0 percent as of December 31, 2018, growing to 3.25 percent by 2024. Holding all other assumptions constant, an increase or decrease of 25 basis points in the December 31, 2018 cash balance crediting rate assumption would have the following estimated effects on the 2018 pension benefit obligation, which would be reflected in the 2018 MTM (benefit) expense, and 2019 expected pension expense:

$ in millions	25 Basis Point Decrease in Rate				25 Basis Point Increase in Rate
2019 pension (benefit) expense	$	(11	)		$	12
2018 pension obligation and MTM (benefit) expense	(125		)		130

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 2018, the Investment Committee of the company’s benefit plans reviewed and approved the plans’ major asset class allocations. The current asset allocation is approximately 45% equities, 30% fixed-income and 25% alternatives, which reflects a shift of approximately 5% from fixed-income to alternatives. At this time, the Investment Committee is not contemplating 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 2018 was approximately 10.9 percent and our 20-year rolling average rate of return was approximately 7.1 percent, each determined on an arithmetic basis and net of expenses. Our 2018 actual net plan asset losses were approximately 3.5 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.

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For determining 2018 FAS expense, we assumed an expected long-term rate of return on pension plan assets of 8.0 percent and an expected long-term rate of return on OPB plan assets of 7.65 percent. For 2019 FAS expense, we have assumed an expected long-term rate of return on pension plan assets of 8.0 percent and 7.67 percent on OPB plans. Holding all other assumptions constant, an increase or decrease of 25 basis points in our December 31, 2018 EROA assumption would have the following estimated effects on 2019 expected pension and OPB expense:

$ in millions	25 Basis Point Decrease				25 Basis Point Increase
2019 pension and OPB expense (benefit)	$	69			$	(69	)

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 2019 MTM expense (benefit):

$ in millions	100 Basis Point Decrease			100 Basis Point Increase
2019 MTM expense (benefit)	275			(275	)

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, estimates of fair value are determined using the best information available. Estimated fair values on these plan assets are based on redemption values and net asset values, 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 (SOA) issued updated mortality tables and a mortality improvement scale, which reflected longer life expectancies than previously projected. The SOA has issued annual updates to their mortality improvement scale each year since then as additional data has become available. These updates generally contained lower mortality improvement projections than the original projections from 2014. After considering the additional information released by the SOA in October 2018, and after reviewing our own historical mortality experience, we continued our practice of adopting the latest SOA projection scale, but with a long-term improvement rate of 0.75% versus 1.0% assumed by the SOA. Accordingly, we updated the mortality assumptions used in calculating our pension and OPB obligations recognized at December 31, 2018, and the amounts estimated for our 2019 pension and OPB expense.

For further information regarding our pension and OPB plans, see “Risk Factors” and Note 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 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.

For further information on litigation, commitments and contingencies, see “Risk Factors” and Note 1, Note 11 and Note 12 to the consolidated financial statements.

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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, 2018 and 2017, 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, 2018, 2017 and 2016.

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.

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 that the reporting unit expects 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, 2018, 2017 and 2016.

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.

OTHER MATTERS

Off-Balance Sheet Arrangements

As of December 31, 2018, we had no significant off-balance sheet arrangements other than operating leases, which largely will be recorded on our balance sheet effective January 1, 2019 in connection with our adoption of the new lease standard. For additional information on our operating leases, see Notes 1 and 12 to the consolidated financial statements.

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NORTHROP GRUMMAN CORPORATION