Northrop Grumman Corporation (NOC) Earnings Call Transcript

Okay. I think we can get started here. I'm really happy to again have with us, Kathy Warden, the CEO and Chairman of Northrop Grumman, back again and fortunately, back in person again. And then also with us is Dave Keffer, the Chief Financial Officer for Northrop Grumman. I think Dave has a couple -- things to say, and then I'm going to hand it to Kathy to say a few words to start us off.

Thanks, Doug. Good morning, everyone. Today, we're going to make some forward-looking statements, and those statements involve risks and uncertainties. Information about these risks and certainties can be found in our SEC filings. We may also discuss certain non-GAAP financial measures, and you can find reconciliations of those measures to GAAP measures within our most recent earnings release. And with that, I'll turn it back to you, Kathy.

Thank you, Dave, and thanks, Doug. It is so nice to be back here in person with you in New York City. I just want to open with a few comments and then we'll certainly address your questions. There is a lot that has happened even since our last earnings report. And certainly, our thoughts are with the people of Ukraine as they deal with both a severe humanitarian crisis and a conflict that we are proud to be supporting for the U.S. and our allies. We are a defense contractor, and so we support the deterrence efforts that are underway as well as the protection of people and their human rights. And so our thoughts go out to the people of Ukraine. In addition, I want to remind you of some commentary in our first quarter call about our strategy because it's very relevant as we sit here today and see what's happening around the globe to reflect on a strategy that we've been executing for several years. The first is to provide technology leadership to our customers in dealing with some of their most challenging missions. And we're reminded of how important those capabilities are today and how those capabilities need to be both innovative as well as affordable. The second theme in our strategy is to align ourselves with our customers' highest priority missions to grow our business profitably. And we've been doing that well. We'll talk a bit about the backlog growth that we've seen in our company and the growth rates that we expect going forward as a result. The third area that we focus on as a company is program performance. This is the way that we deliver margin performance in addition to driving cost efficiencies. And then finally, we have been very forward in our capital deployment strategy, both investing in our own business to support that growth outlook that I talked about but committing to returning cash to shareholders as well, and I'll lay out some specific commitments that we've made. So all of that results in a financial outlook that projects low single-digit growth this year, accelerating that growth into 2023. And as we look at the budgets that have been released now, the President's budget request as well as the 5-year plan, it shows strong support for programs in the Northrop Grumman portfolio, of course, most notably the B-21 and the Ground Based Strategic Deterrent but many others as well. As a result of that and the strong program performance we've had, we are also projecting to see expanding margin rates, so this year, projecting at the midpoint of our guidance, 11.8% segment operating margin, and have indicated that we expect that to grow to 12% by 2024. And then finally, with strong cash flow outlook, we have committed to expectation of a double-digit compound annual growth rate on free cash flow by 2024 as well. And what that means is we have been able to have a capital deployment strategy that robustly supports the growth of the business, investing back into the business, but also, we have committed to return 100% of our free cash flow to shareholders this year. We are outlining a plan for $1.5 billion of share repurchase this year, at least, and we also have just raised our dividend by 10%. And our dividend sits now at almost double what it was just 5 years ago at the beginning of 2017. So a strong commitment to returning free cash to our shareholders. So with that backdrop, I'm happy to answer any questions that you have, Doug, about the portfolio and the outlook.

Great. Well, thanks, Kathy. To start, you mentioned the DoD budget, and clearly, B-21 GBSD, very well supported. Can you give us a little more insight into -- if you go beyond those 2 programs, how does Northrop Grumman look based on that budget, and I'll add one thing to it and based on potentially what Congress might do in addition.

Yes. So from a technology leadership perspective, we align well with the budget request primarily because the U.S. has outlined a strategy that focuses on high-end conflict, and that aligns well to a portfolio like ours that is more sophisticated systems, that support air, space, ground, land and subsea and cyber. And so when you look across the breadth of our portfolio, we see growth opportunity in all of those segments, but most notably Space, where we have 3x sales backlog in our Space business that's already been built. And it is our fastest-growing segment of the business and continue to see awards growth there into this year. We also see Mission Systems as a segment of our business that's very well supported in the budget. It is communications, surveillance, processing capability, all of which is highly relevant in today's environment. In some cases, those are programs where we are the prime. In other cases, it's efforts like the modernization of the F-35 where we're a key Mission Systems supplier. And across the whole of our portfolio, we see strength into the later part of the decade, in AS, in particular, where we've seen some headwinds for programs that are retiring, we see growth emerging with B-21 moving into production in the next couple of years.

I'm curious, with the Russian invasion of Ukraine, are there any things directly tied to that, that affect your potential revenues here?

We see some short-term opportunity, particularly in our weapon systems business. Think ammunition, small caliber and medium-caliber cannons. We also have some work in airborne missile systems that are relevant to the Ukraine fight. But at the end of the day, the bigger impact that we expect is with European allies expressing increased support for budget growth in the next several years. That won't manifest itself in revenues in 2022 or likely even in a significant way in 2023, but we do see it creating upside opportunity to the mid part of the decade. And that's broad-based. That's aeronautics, that's our Defense Systems and our Mission Systems portfolio.

When you look at a couple of the big programs, and B-21 is clearly a standout. I know it's hard to talk about. But we recently saw statements coming out saying that first flight would be pushed back to 2023. Can you talk about, to the extent you can, sort of how we should think about the schedule on this program? I know there's been a lot of commentary that it's on schedule, on budget, which is something I never hear about when it's a major new military aircraft program. But just help us understand, when you see, this is the second time we've seen headlines with first flight pushback, how do you reconcile those things?

So there's a bit of a misconception and it's understandable that it needs reconciling. We are still ahead of the acquisition program baseline date for first flight on the B-21. And so as you have heard other dates unofficially circulated, those dates were early projections of how soon the aircraft might get into first flight, but those were never changes, they were never official dates. And so as we sit here today, what we talked about in our first quarter call is an outlook for the program incorporated what the Air Force now has officially said about when they expect first flight to be in the early part of 2023. And so with the first flight milestone date being later in 2023, that's why you hear from Congress and the Air Force that we are still on schedule. We are still within the time line that they projected for the program. And to your point, the same is true on cost. Even though there's been less information externally provided by the Air Force about cost, what we did say in our earnings call and first quarter is that we look out at the program and the commitments that we made in the proposal for the program and expect to be able to meet those cost targets and profitably deliver the aircraft.

Just when I look back, and I mentioned that there's a long history of major new aircraft programs that didn't go that smoothly. But it seems that the time when things often break down, it's actually around that first flight point that a lot of the risks really start to build up. I mean, how are you thinking about that internally? Have you done things differently that hopefully would mitigate risks at that point in time?

Yes. We've absolutely done things differently on this program, and that's what I'm most pleased with. In combination with the Air Force, we have worked through a development cycle and now into a test cycle that really is less about meeting a first flight date and meeting a level of maturity for the aircraft, meaning we have wrung out the software before it will ever fly. We have wrung out many elements of the design before the aircraft gets airborne, so that we're less likely to find those things when we go to first flight. We have done much more of the integration and testing already on that program. The government also worked with us to ensure that we were building a production representative aircraft. Many aircraft before had worked toward just getting a development aircraft in the air and then figuring out how to make it more producible and meet certain criteria like weight or even range as they went from development into production. We have done that work as we have worked through the development phase of the program. And so it gives us a much higher confidence in more mature aircraft as we prepare for first flight. So when the government talks about a production-ready aircraft for first flight, that's different than what most aircraft programs have done in the past.

Yes. That's absolutely different, yes. So now with this big ramp-up in funding, how should we think of the profile for revenues on the B-21 over the next few years?

So we do expect that after we achieve first flight milestone, we will begin to move into production in earnest and low rate initial production. If you look at the 5-year budget plan, the [ FIDP ], it shows production being laid in now for the first time, that's visible. And you can see the government has not released the rate, the quantities that will be built, but you can get a sense of the size of the budget that's supported for B-21 production, and we're already working under advanced procurement dollars on those first aircraft.

But we probably shouldn't -- we wouldn't expect to see -- I mean, this is sort of starting, I would think, in 2023 when we will start to see revenues come up because what I'm trying to do is to think through these mature programs that decline that led to sort of lower aeronautics revenues this year, trying to picture how that transition goes.

Right. So what we've said is that for Aeronautics, we expect the segment to be roughly flat in 2023, with B-21 providing growth, but the retirement of the Global Hawk and Joint STARS being a headwind in comparison to 2022, those 2 things roughly offsetting each other for the segment overall to be flat going into next year and then returning to growth in 2024, and that partly is fueled by the B-21 continued growth in 2024.

And so perhaps you could walk through -- I mean, when I think of some of these -- I mean, actually, I think we've talked about this on the earnings call, but when you think of some of these programs that are coming down, you've had -- Global Hawk looks like -- I'm not sure where E-2D is going to go in a couple of years. I mean, how should we think of these programs that are sort of more mature and declining?

So Global Hawk and Joint STARS, we see to have some headwinds still into 2023 on a year-over-year comparison basis and then those will largely be out of the system, if you will. And then as we look at B-21, as I noted, that alone will largely offset those declines in 2023 and provide growth into 2024 when we don't have those headwinds from Global Hawk and Joint STARS. With E-2D and F-35, the other 2 large programs that drive Aeronautics revenue, those are roughly flat over that period. And for E-2D in particular, the Navy reaches its program of record quantities and that would start to impact us in 2025. However, we have international sales. We just signed a France award, and we have other countries that are expressing interest and expect international to begin to fill in, in that 2025 time frame. So for E-2D, it's a little early to say what that looks like past 2025, but it's not a headwind in the next couple of years.

But one of the things that surprised us a little bit was the size of the budget for Triton. So does that -- I mean, it was $1 billion. I mean, that's -- is that some upside from what -- and were you expecting that or is that upside from where you were?

We were expecting that. The Navy took a production pause for 2 years. We had a couple of aircraft but this is returning to their expected program of record quantities on the aircraft. So we were expecting it, but clearly, on a year-over-year basis, it is growth.

Yes. So if we switch over to GBSD, can you give us a sense of where we should expect that to go over the next 3 to 4 years? How large can that program be in revenues?

So for the Ground Based Strategic Deterrent, now called Sentinel, if you hear that terminology, that's the name that the U.S. Air Force gave to the program, we are expecting that program will continue to grow through next year. We're adding about $0.5 billion of sales this year over last and about the same is expected into next year. Then we do expect it to plateau for a couple of years before going back into a growth mode as we transition that program into production as well. And that really starts to kick in, in the 2025 time frame production on GBSD.

Now on B-21, I think of the transition to production is probably somewhat similar to normal large aircraft program while you go through LRIP, and full rate production margins then go up when you go to a fixed price contract and it matures. How does GBSD work? We haven't seen too many programs quite like GBSD. What should that margin path look like?

Similar. In any large development program, we generally start with a lower booking rate as we're sitting with a lot of risk ahead to retire. And as we retire those risks successfully over time, we can increase the profitability on a program that's cost plus development as GBSD is. Then as we transition into production, margin rates improve there over time as well and production usually starts higher than development ends. So that would be the normal progression for a program like this. With GBSD, unlike B-21, we have not bid the production. We've only bid the cost-plus development phase of that program. So that will be something that we bid later in the program when the design is more mature and that should lower risk as well. We'll have a more mature design as we bid that fixed price work.

And I mentioned you often see around first flight on a new aircraft program where the risks are. On GBSD, what challenges do you see? Is there a point we should focus on to think, this is probably where the most risk is and the hardest part to get through?

On any program integration, test tends to be where you find things in the design that need to be addressed. And yet with our programs using a digital backbone for them, that started with B-21, it's even more mature with the Ground Based Strategic Deterrent, where we are doing everything from design through production in very sophisticated models. We believe that, that is significantly going to lower the risk of these programs and allow us to identify any issues that we might have, in previous instantiations on a program encountered, in integration and test, discover those much earlier and address them in the development phase, which rework is the major cost driver on programs like this. So to the extent that we can reduce that with more mature modeling upfront, we think, puts us in a better position. So for GBSD, we're also in that situation where we're wringing out a lot of that risk even now as we march toward our critical design reviews on that program and then expect to get into a mature build so that what we're testing is highly proven in models before we get to that phase of the program.

Now if we look at Space and I put GBSD aside, I mean, Space, it's the fastest-growing part of the budget. Your backlogs are way up. Can you help us at all understand the other programs in there and what is allowing you to get this high growth?

Yes. Space, the portfolio is broad and so I'll give you a few representative examples. First of all, I should start by saying 40% of the Space portfolio is restricted and so the program details are not ones that we can broadly speak to. And that's a reflection of the capability in that portfolio to support some of our customers' most important mission areas. But there is also the 60% that is not restricted, and it's things not just GBSD and Next Gen Interceptor that are large singular programs, it's a couple of hundred million dollar programs. Some examples there are the Space Development Agency's Tranche 1, which provides a communications backbone. We're going to build 42 low-Earth orbit satellites that will be part of that comms backbone. We also were, just in the first quarter, awarded a program called DA/RC. It's a deep space radar capability that provides situational awareness, particularly in the geostationary orbit. And so those programs give you a sense of we can operate in multiple orbits, multiple types of capability. DA/RC is more of an ISR capability, whereas Tranche 1 for SDA is a communications mission. And we also work across other parts of the government. NASA's growth, which is 8% in the budget this year, is largely supporting programs like Artemis where we are a contributor on multiple pieces of that architecture to return a man and put the first woman on the moon. And then we have commercial work as well. We are about to be awarded a contract from ULA to support the Amazon Kuiper launches and that would be approximately $2 billion, so another significant award.

Well, in -- when you look at Space and if we went back 10, 20 years, then you think of things like CBERS, AEHF predominantly, lots of large -- I mean, there certainly were classified LEOs and things like that. But you think of it as more of these large exquisite satellites. Today, this has all shifted where a lot of the new programs are at sort of different layers. You've got complex networking issues to think about. How do you look at the mix of Northrop Grumman's Space business sort of this standpoint, without -- I can't get into classified programs, but how's it shifting?

I would tell you, our portfolio is purpose-built for the environment we're facing right now. I could not ask for a better portfolio than what we have in terms of the range of missions that we're able to support and the knowledge that comes from both legacy Northrop Grumman, legacy Westinghouse, from that acquisition many years ago, to legacy Orbital ATK. Over time, we have assembled a portfolio that allows us to develop fast, affordable solutions that can go into LEO and support proliferated low-Earth orbit. We can support much more sophisticated payloads, as you referenced, for missile tracking as well as surveillance and anything in between. And we can provide support to launch with propulsion solutions. We can support the bus, the framework of the satellite, the payloads that go on it. So we are able to solution with the government and think about what's the best solution for their given requirements and pull from our toolkit inside the company. It allows us to be much quicker than if we had to go outside and partner significantly, and it allows us to be more affordable.

So I think -- when I think back to more traditionally where Space was, you could sort of look at these satellite launches, you get paid per satellite, that sort of thing. Those things were complicated and risky. Some went more smoothly than others. But today, you've got a lot of satellites that the customer views as the bus itself being a commodity, and you do those on a fixed price basis. You've got a lot of new entrants coming in there. I mean, how do you think about the economics of this business, particularly these -- a lot of these LEO constellations as you go forward? It's got to be different.

It absolutely is different. And so while we can build a satellite bus, we don't build all of our own. For SDA, as an example, we are partnering with another provider because what that required did not meet the criteria for what we currently build, so we went out and partnered. And we're very open to that kind of a model. And we run what we call pitch days where in different parts of our portfolio, we go out and invite in many companies, some of which have a pure commercial model. They don't know how to do business with the government but are fine entering into a commercial relationship with us, and then we can bring those technologies into the Department of Defense. And so we have built our capability inside the company to really be responsive to what our customers need and what can hit the appropriate time lines and price points that our customers require. We brought some of that commercial expertise into the company. But we also, as I said, need the systems engineers that can put that whole solution set together. And that's the value we bring and why we've been as competitive as we have, even in these capabilities that do hit lower price points, as you note, than what we might have built a decade ago.

Because another aspect of the economics when you go to the low-Earth orbit satellite is they don't last as long?