Northrop Grumman Corporation (NOC) Earnings Call Transcript & Summary

I'm Citi's aerospace and defense analyst. Before we get started, I want to make a small plug. 1:15 p.m. on this floor, in one of these rooms, we're going to be having a session with [ McKinsey ], talking about the defense industry in the 2020s with the session titled, What is on CEO's Minds. And I thought right now will be really helpful to go right to source here with CEO of Northrop Grumman, Kathy Warden, who joins us as well as Todd Ernst, who's the Treasurer of Northrop Grumman and also Investor Relations. I'm going to hand it over to Todd briefly to go through a few of the formalities.

All right. Thanks, Jon. Before we get started today, I'd like to remind everyone that today's discussion involves forward-looking statements, and those involve risks and uncertainties that are detailed in our SEC filings.

Thanks, Todd. Jon, thank you for having us today. I wanted to share a few opening thoughts with you, and then I'm looking forward to getting into some of your questions. A few weeks ago, we reported our 2019 results, and we're pleased to again report a solid year for 2019. We are growing our business. We generated strong earnings and cash last year. We put that cash to work. We've been investing in our business to position for growth and strongly returning that through good margins and performance into cash. And our capital deployment strategy has remained consistent, while we're investing in ourselves. We're also offering dividend increases on a yearly basis. We've done that for the last 16 years. We're buying back our shares, and we're really maintaining a strong balance sheet and continuing to pay off the debt that we took for the Orbital ATK acquisition. So as we look forward into 2020 and beyond, 2019 was a strong positioning year for us. We had book-to-bill of 1.3x, generated $45 billion in new awards, and we also were able to grow our backlog by 21%. So that positions us nicely as we look out into the future and through the growth campaigns that we put in place early last year. We're seeing strong results. So I look forward to having the discussion with you today about the state of the business and how we see the business growing in the future.

Yes, sure. Thank you very much for that.

I thought maybe I'd start with a small anniversary here. I think you took over officially the -- CEO on January 1, 2019. Just give us an overview of what have been some of the focus areas and lessons learned since taking the job.

Yes. So you're right. I can't believe it's been over a year at this point. And we have made some changes in the business. We built on a strong culture and a performance track record. And last year, at the beginning of the year, we also oriented the team toward a growth strategy. And that growth strategy was supported by a new incentive plan that messaged to the team the importance of growth, not just growth, but profitable growth. So we added to our short-term incentives, a measure around segment operating income growth. Throughout the year, last year, we executed on those growth campaigns, as I mentioned, and had strong results. And at the end of the year, realigned the business to better be able to execute those campaigns. So at the beginning of this year, we started operating in a new 4-segment structure. That, in particular, aligned us to grow our Space business and created a new Defense Systems segment, while also maintaining our focus on both Aeronautics and Mission Systems, which are a strong part of our portfolio, have been and will be as we grow the business into the future. So a number of changes all oriented toward the teams focused on performance and then elevating the focus on profitable growth. We also have been very focused on people because our business is largely generated through the ideas and the talents and expertise of our engineering workforce. Last year, we grew our talent by about 13,000 new hires and through attrition overall had 7,000 new positions in the company. This is really important to fuel that growth that I spoke about. And we always want to attract the top talent. So we also did some rebranding last year as a way to message our purpose and attract the talent that we need for our company.

Yes, I was going to ask about some of the more visible changes you made and certainly the new logo is one of the most visible changes and it appears everywhere now. Going back to the new segments, those are one of the big changes that you did make, what -- I mean -- and you sort of linked that to the idea of profitable growth. When and where should we externally expect to see some of the tangible changes? Or is it more of a way to enable you to manage the business more effectively?

It's both. We do see this new structure enabling that growth because we've put together pieces of the portfolio that have natural synergy. When we acquired Orbital ATK, we knew that our Space business would benefit from the addition of the Space portfolio in Orbital ATK, but we had our Space business operating in 3 different segments: our Aerospace business, our Mission Systems business and the Innovation Systems business in our old segmentation. Now we've brought all of those pieces together into a single space sector, and that team is able to focus on solutioning, bringing new ideas to our customer, which will allow us to capture new work and grow the business. But it also will improve our ability to perform because we have all of that engineering and production talent now oriented into one business aligned towards common goals and working together and sharing talent more fluidly.

Staying on the idea of change. You mentioned -- so new logo, new segment structure, new incentive structure. What about this environment has prompted some of the change in the incentive structure? And also in the way you've approached your investment philosophy as well as some of the personnel changes that you've been making as well.

Yes. So 2 focus areas for us. Within profitable growth, we don't just want to grow the business in any area. We wanted to grow it in areas that are well aligned with the National Defense Strategy and make sure that our investments were put in places that we could see long-term, what I call, durable growth. That even if our nation took a pivot, that we would be aligned to technologies that supports the threat environment, not only as it exists today, but as we anticipate it will exist in the future. And so those campaigns were purposefully selected in the areas like space, hypersonics, counter hypersonics, counter UAS and all domain command and control. These are areas that our customers know they need capability, and will be, we believe, best protected in the budget environment going forward. And so those campaigns allowed us to make sure we are investing in the right areas. But the second part of our message to the team was we want to position ourselves to be competitive in those areas as both a leader, a prime systems integrator as well as a supplier. And this was particularly as important as we were bringing Orbital ATK into the fold because we are a good supplier to other primes across that set of missions as well. And we've aligned our strategy to be able to support both. And that has opened up more growth opportunities for us as an organization.

I think you touched on some of the personnel changes you made. I know with the segments comes new leadership as well. I know you come from actually kind of running that operational business as well. So I'm curious on the leadership side.

Yes, we have made some shifts in the leadership of our segments. One new leader for our Defense Systems sector as the leader of our Technology Services organization retired at the end of last year. And I've made a couple of changes on our functional team, including our new CFO, Dave Keffer, who is here with me today as -- and our strategy lead at the end of last year. And really, that's an orientation to having leaders in the corporate office, who can help us to drive that profitable growth strategy across the company, working with the segments to not only deliver growth, but ensure that we're getting the return on those investments that we put in place to deliver that growth.

It's a great segue to the next topic almost is investing. And we talked about it a lot already in terms of positioning in the right areas. But can you -- when you think though about some of the buckets of investment. You guys have been pretty big on CapEx. You lean forward on R&D. There's always been a proposal. There's always building out technology, capabilities. How do you think about -- maybe they're not different buckets, but how do you approach those various options for it? I mean there's personnel investments, too. How do you approach those various options?

We want our investments to be aligned to areas that we know will create long-term and enduring value for the company. And that's why we take a strategic approach when we think about those investments. And we take a very aligned approach. So we're not making that investment just within a single business, but we're thinking about the capability of the entire enterprise and bringing it together in a unified way to both make the investment decision, but then to execute on that investment, and we've done that quite successfully on some of the larger opportunities that we have won and that we are positioning ourselves for. It is because we brought the power of the entire organization and had an aligned investment strategy that we were able to differentiate ourselves, not just technically, but from a business model and a cost structure perspective, enabling us to win those opportunities. So we think about investment from a market basis. Are we aligning to the right long-term investment areas? We think about it in terms of returns. Are we going to be able to leverage that investment broadly across the enterprise into multiple opportunities for long-term shareholder returns? And are we able to successfully execute our work if those investments are made? Are they buying down risk that helps us to have a more profitable revenue stream for that work in the future? And we have done quite well in the past in successfully executing risk retirement, and that has driven performance and it's driven margin improvement, and that's how we focus on investments as we think about our portfolio in executing it day in and day out.

When I go and look at the -- and everyone sort of pores over the defense budget, obviously, for better or worse. Last week, it was released and no real surprise from a top line perspective. I think the overall message is that you have slow -- a deceleration in growth and spending set against a -- so the numbers are decelerating in growth, but the message coming from the customer, and you're very close to the customers, so I'll let you talk about that, too, close than I am, is that the threats are not decelerating. The threats are actually accelerating. So that plays into this idea of affordability. How do you address customer needs for affordability? What does that mean to you? I know it's sort of a catch-all question. But matching up the acceleration of threat and the deceleration of resources, how does Northrop deliver there?

Yes. So we think about affordability in 3 ways. First of all, performance drives affordability. We want to avoid cost overruns that are costly for our customers and degrade customer satisfaction. So performance is element number one. Element number two is our cost structure, managing our costs over time and that we think of in multiple ways. Obviously, as we were integrating Orbital ATK, we have the opportunity for cost synergy, and we exceeded our target for cost synergy in that integration. We're also managing our cost structure every year and thinking about where can we be more efficient in our operations, where can we use technology to drive down the cost of executing our business. And then the third area is just the general focus on the solutions that we design. Are they designed to be affordable? Are we able to create a solution that serves multiple customer needs from one technology base? And are we able to do more of our solutions in software today, so that it's less costly to upgrade them over time and that we're able to show that value stream to the customer, not just in the original development but in the maintainability of those products. So those are the 3 ways we think about affordability. And we are, every day, driving our team to think about new ideas in each dimension of that affordability equation.

Any thoughts as to addressing the difference between the acceleration of threats and deceleration of resources? And I think the customer has said that he wants -- or the Secretary of Defense, at least. He's one of your customers. Has said that he's looking for 3% to 5% growth. That's not what's in the plan right now. I mean is it just answered by affordability? Or how do you think the country kind of addresses that kind of dynamic at this point in time?

Right. The Secretary has been quite clear that we need 3% to 5% growth to be able to preserve the investments that are needed for our nation's security. And through those discussions, it has become clear that prioritization is one way and affordability is the other. Industry is working on affordability. The Department is being clear about their priorities. And part of what Secretary Esper did this week in bringing industry together was to talk about the alignment of the FY '21 budget request to the National Defense Strategy, and where his priorities are so that we, as industry, know where to best place our resources and investments to be responsive to those needs. And certainly, we're all advocating for continued, strong defense spending because he makes a very valid point. The world is not becoming safer and the threat landscape is proliferating. So we need to, as a nation, be able to resource ourselves to remain at the forefront of addressing those threats.

Understood. So a bit of a needling question, but I know you've probably gotten this question on growth over the last couple of days, weeks, quarters. And you've only been CEO for a year, so it can't be more than that.

Oh, but I can. I was COO before.

Yes, that's true. Yes, you're right. That's true. All right. So I'll take that back. So you've been getting this question for a little bit, but I guess I'll just put it this way. In this environment where you've had good budget growth, I'll set up this way, why would growth stay roughly the same rate in '20 versus '19? I know there's some disclosed headwinds. But what's the opportunity to accelerate beyond those headwinds? And when might that be?

Yes. So the budget top line is important as it provides the foundation for the programs that are funded within it. But really, for any individual company, it is far more important how the programs that you're working are supported in the budget and what their relative priority is. And I feel very good about where our company is positioned. The strategic deterrents, the nuclear triad is a top priority of the Department. And it is that way because of the threat environment that we find ourselves in. And so I believe that prioritization will endure. Areas like space, high-speed weapons, being able to defend against adversaries, weapons are areas of great importance and we believe they will continue to be. Our portfolio is well aligned in these areas. It is where we have seen our growth in backlog come in 2019, and it's where we anticipate our backlog growth to continue to come from in 2020, which positions us well as you look at 2021 and beyond. And even if budgets begin to flatten out, those programs will still see growth because they are preserved in the budget and remain the highest priorities of the department.

It's sort of a -- something strikes me when speaking to folks in your seat and others. Talk about the budget, it sets the tone, it sets the backdrop. Does it even matter? I mean I know it matters, but a couple of billion dollars up and down, here or there, if you're making the right investments, does it really even matter? And I don't want you to dismiss the budget but...

It matters. It matters because, again, it is the baseline from which we need to operate and which choices are made. And if the top line is lower, there are harder choices to be made. And those choices are not the full authority of the department. The Congress has to support those choices as well and enact appropriations. So we certainly care about the top line, but we care more about the programmatic support within the budget. And those -- that really is what determines a company's view of whether they've made the right investments and they're supporting the right programs over the long term.

So we should look at your backlog growth as being quite indicative of where the future could be in terms of the growth profile for the company?

And the areas in which it has come. The fact that it's highly aligned to the National Defense Strategy, as indicated by the amount of classified work that we are currently executing, but also what that represents in our backlog, which for our company is about 25%. Strong alignment to those high-importance areas of technology that our nation wants to guard in a classified setting. The fact that it's come in the areas of space, advanced weapons and command and control because those are the priorities of the department. And the fact that their early phase development efforts, which has a multi-decade view ahead of them versus the growth coming on production programs, which are ramping, but nearing their peak. And so when we look at the portfolio, we feel really good about where the growth in backlog is coming from not just the fact that it grew 21%.

Great. Some mid-single digits with some disclosed headwinds is a good starting point, that would be fair to say?

Yes. And that's what our guidance in 2020 reflects. But again, when we make investments, we're making them for the long-term and not for a single year return or a single year growth rate.

Yes. That's fair. It's a long cycle industry.

It is.

A very long cycle industry, actually. When you think about margin, I know of top -- you talked about profitable growth. So what are some of the drivers behind overall segment margins, maybe by business as well. And then there's mix, there's some synergy flowing through the new Space segment still. How should we think about that dynamic in this growth environment?

So as we've taken on more early phase development work, there has been mix pressure on our margin rate, but it's remained relatively stable because we've also been working the cost structure and been able to continually improve our costs. One part of that is the cost synergy that we got from the iteration of Orbital ATK. And I will note that, that is not just benefiting the space sector. Those synergies are supporting the entire enterprise as we look at reducing the amounts of our costs that get allocated to the business in general and that spread across all of our segments. So some of the businesses have more mix pressure than others. And some of the businesses are receiving more cost synergy than others. So you see a little bit of fluctuation in margin rates with some having more pressure and some having more opportunity. But at the company level, when you aggregate it, our segment operating margins have remained strong, and we anticipate that will continue.

You brought up, obviously, the Orbital's -- specifically the Orbital integration, thus far -- I won't ask you to grade yourself, but it seems like the progress that has been made has been generally positive. Some faster recognition of revenue synergies than you initially built into the model or expected or communicated at least. So what have been some of the steps that you've been able to take since closing on that deal, a little bit now, in order to drive value?

Right. It will be 2 years in June, and we feel very positive about the progress that we've made. Clearly, the financial commitments that we made to generate cost synergy and the fact that we did accomplish what we said we would do which is $150 million of cost synergy run rate by the beginning of this year, and we actually exceeded that. We said that we would generate revenue synergy, and we have been open that, that revenue synergy is coming even more rapidly. And I pointed to some of the synergy opportunities that we won last year that were part of the backlog growth that I've been talking about. And we also look at how well we've been able to preserve the talent that we brought in, in the integration of the team. And that has also been exceptional. It's been a good cultural fit as we brought the 2 organizations together. Our teams are working well together. And we've been able to retain that expertise that was so important in building Orbital ATK into the company that it was, and we want that value to continue to be preserved in the Northrop Grumman combined entity. And so on all of those dimensions, I feel really positive about where we are. Now we need to take that value to the next level at the new alignment in taking pieces of the Orbital ATK business and putting them into segments with legacy Northrop Grumman business so that we can accelerate even further. That revenue synergy is our objective, and we're also getting to operational synergy. Looking at co-use of facilities, co-investment, this will reduce our cost in those operating areas still preserving our ability to grow capacity and support the revenue synergy that we're getting. So all dimensions, we are exceeding our expectations for this deal, and it looks great financially. It looks great from a portfolio perspective and a talent perspective as well.

It just strikes me that when you first took them in as its own segment, externally, it seemed like its own segment, just -- I wouldn't say out of convenience, but there's a certain element of -- it's a great asset onto itself, and you're able to realize what you want to realize in that setting. In this new setting, you use the word "acceleration" a lot, which would suggest that there is still more to come.