Northrop Grumman Corporation (NOC) Earnings Call Transcript & Summary

Hi. Good morning, everyone. This is Jon Raviv. I am Citi's U.S. aerospace and defense analyst. And welcome back to Citi's Global Industrial Conference, virtual version. Very clearly today, if you're anywhere in the northeast, you're definitely not in Miami right now. And I hope everyone across the country experiencing adverse weather is safe and sound. We're joined this morning by Northrop Grumman. Very pleased to have, very honored to have Kathy Warden, CEO; and Dave Keffer, CFO. We'll be spending the next 40 minutes having a bit of a conversation about where things are right now for the company, for the industry. And before that, though, I'll hand it over to Dave for some safe harbor comments. And I know Kathy has some brief opening comments to make, and then we'll get into our conversation. So again, thank you, Dave, for being here, and over to you.

Great. Thanks, Jon. Good morning, everyone. Before we start, I just want to remind everyone that today's discussion involves forward-looking statements. Those statements involve risks and uncertainties, and information about these risks and uncertainties can be found in our SEC filings. So with that, over to you, Kathy.

Thanks, Dave. And thank you, Jon, for hosting us this morning. It is definitely not Miami, and we were happy to be with you there a year ago. So much has happened in the last year, and my condolences go out to anyone whose lives have been touched by COVID-19. We certainly throughout the last year have kept the focus on the safety and well-being of our workforce. And while we did that, we were able to accomplish some extraordinary operating results. So I just wanted to start by giving a sense of what 2020 looks like for the company and where we're headed. Looking back, for 2020, we grew the business 9%. We continued to deliver strong operating results and exceeded our own expectations for earnings per share and had very robust cash generation. Over the last 2 years, we have had book-to-bill of 1.3x and 1.4x, respectively, which has given us a really strong baseline to move forward. And in addition, we've accomplished what we set out to do strategically. Two years ago when I stepped into the role of CEO, we were working on the successful integration of Orbital ATK, and I'm pleased to say that not only did we achieve but we also exceeded our expectations for both cost synergies and are doing so with revenue synergies. We restructured the business to gain further revenue synergy across our portfolio, and earlier this year, we divested our IT services business. So we now have the portfolio that will position us well for the next several years. And in doing so, we've also created the capacity to implement our capital deployment strategy. We continue to invest in the business, pay a healthy dividend, but we also have increased our share repurchase. You may have noticed that earlier this year, we talked about a $2 billion accelerated share repurchase program that we entered into. And we indicated that we plan to do over $3 billion of share repurchases this year. So with all of that said, we are sitting -- headed into 2021 with some great momentum, strong operating results and really looking forward to the future. So Jon, I know that's what you want to discuss more, and I'll turn it over to you so we can get started.

No, that was such a good opening that I think we're done with questions, so we can just call it a day. But no, Thank you for that. And again, appreciate you both being here. Clearly, good to see you again, and hopefully, again, we'll be in person in Miami next year. But given what you said, heading into 2020 with great momentum, and it's interesting that over the last few years, you have made a lot of changes and repivoted and resegmented and added and subtracted, and here we are with the company as it is now, so it is a bit of a new entity moving forward. What does that say about where the company is for the long-term position of the defense industry? What does the future defense industry look like? And how has this company been shaped to address that?

Well, I could talk for hours, and I did just do interview with CSIS a week ago on defense in the 21st century, and we talked at length about where the industry is headed. But to recap some of what I covered there, we believe that over the next decade, we'll continue to see great power competition as the key threat driver for the U.S. and our allies. And as a result, we have been and continue to position the Northrop Grumman portfolio to address that high-end threat. That includes looking specifically at China and Russia and having the capabilities to engage each of those nations as well as continuing to be able to operate on a global scale. And the U.S. Department of Defense has been pivoting budget in this direction. We expect that's going to continue under the Biden administration. Early appointments in the Biden administration, specifically in the Department of Defense with the Secretary and the Deputy Secretary, they have indicated that China will continue to be a primary focus. As a matter of fact, last week President Biden was at the Pentagon announcing a new task force on China. So when we look at the Northrop Grumman portfolio, our capabilities in stealth; our abilities to detect through Mission Systems the adversaries' networks as well as their defense systems and to defeat them, both with kinetic and nonkinetic operations; position us well in that high-end threat.

Yes. And it's interesting that given -- I mean I think we had -- we've been talking for years about this dynamic where the budgets are what they are. They're relatively elevated, and there's a wide expectation, given where that sits especially, that the spending has to come down. At the same time, though, when you listen to the DoD, you listen to folks in national security sphere, you listen to folks in industry, they talk about a very active pipeline with a lot of things coming in, a lot of new things, and that's been -- and that's what's driven a lot of the big investments that you and your peers have made over the last few years. With all of that as the backdrop, these stocks, including your own, has derated, underperformed a bit recently, largely based on those budget worries. I mean I struggle with this, and it's my job to figure this out. But I'm curious what your perspective is. How does one overcome those doubts when it comes to things like budget? Or you just got to let it roll, and we'll see you in a couple of quarters and you'll see what our performance is?

Well, I think 2 things need to be kept in mind. First, we continue to perform well as both a company and an industry. And at the end of the day, that's generating strong margins and cash flow. So even as we talk about budgets starting to flatten, budgets are at a healthy level, and our companies are performing well and creating value in the current market environment. And I expect that to continue even in a flat budget environment. The second thing to keep in mind is that when we have an administration change, there's always great concern that a new administration will take a fresh look. But that fresh look is always informed by the threat, and the threat is not changing. As a matter of fact, I would suggest that the threat is evolving and getting more significant, such that the budgets will have to continue to stay somewhat robust and stay aligned against that evolution of threat. And the Biden administration has already started to talk about their intentions to do just that, even putting more money into things like research and development for key technologies like artificial intelligence, advanced networking and computing, which we have been investing in for a while and are pleased to hear that the government is planning to invest more in those areas. So it's not necessarily about whether the top line budget remains flat, it's about what that money is spent on and the capability that the U.S. gets to address the threat as it evolves, and how a company's portfolio is positioned to capture share even in a flat environment.

Yes. No, that's appreciated. And you mentioned how some of the items that the government is focused on right now are items that you as a corporation have also invested in over the years. So that brings me to the question of investments generally. I mean how do you approach investments for new programs that could include CapEx, bid proposal dollars, technology enhancements? And what's the typical payback? Or how do you approach that payback calculation when you make those investments?

Sure. I can touch on that one, Jon. It's obviously a complex set of dynamics. It's not as straightforward as a simple calculation, our hurdle rate that guides us toward every answer there. With that said, clearly, the opportunity set we've seen over the last half decade and beyond has been such that our investments in R&D and CapEx have been at elevated levels over the last couple of years. We've seen ample opportunity to differentiate and grow through investments. Our R&D has been at around 3% of revenue, our CapEx north of 4%, both of which are kind of high watermarks for our investment over time and both of which we'd expect to moderate a bit as we've talked about in the coming quarters and years. With that said, I think it's demonstrative of the strength of opportunity set that we have seen and, frankly, continue to see. To the points you and Kathy have made already, as we look at 2021, there's an ample pipeline of opportunity. When you're a company, as we are, that focuses on innovation and engineering excellence and designing and developing and manufacturing some of the leading capabilities and technologies in this defense market, you can't shy away from necessary investments, especially in a market like this where for certain opportunities and certain contract structures, like OTAs, there's often some investment required alongside the government, particularly in earlier phases of a program, in order to reach the phase where you reach a more normalized business case in this market. And so we've been careful and selective but proactive about making the right investments to differentiate ourselves and enable the kinds of growth we've seen in recent years. Going forward, though, we expect to continue to make those prudent investments. But regardless of market growth and market conditions, we don't anticipate changing the strict criteria that we have around business cases for investments in R&D and capital expenditures, independent of market growth conditions. We've walked away from some business deals in the past that we've determined have not been the right risk/reward opportunity for the company, and we would continue to do so in any environment going forward. Clearly, the differentiated capabilities that we're offering and solutions we're offering to our customers have produced ample opportunity for us in recent years. We expect them to continue to going forward, and we'll make sure we continue to apply those strict criteria.

Yes. And one of those things I feel like companies often invest for, or at least have to keep in mind, is this idea of affordability. And so the customer talks about affordability a lot. How do you address those needs? Especially as the customer has to say, "I need something affordable. I feel, at that top level, resource constrained but I also have this accelerating threat environment to address." So how does that affordability dynamic play in starting now, and how do you address it?

Affordability perhaps is in a heightened focus in an environment where market growth slows. But that's not to say that affordability is not critical in almost any market environment. As we pursue any new business opportunity, we look to provide great business value for the government and our customers as we achieve their mission outcomes, help them achieve those outcomes. So affordability has been important to us all along and to our customers all along. We do feel like we've laid a good foundation for ourselves to be affordable and competitive in the environment going forward. The Orbital ATK cost synergy, I think, is one example there. Our lower-than-peer-average pension costs are another kind of structural cost advantage we've talked about over time. Beyond those, we look to continue to drive efficiency in all that we do. Our agile and digital transformation efforts are a good example there. Clearly, we've talked about, and government customers in several cases recently have heralded, our efforts around digital engineering and design efforts for programs like GBSD. Those reduce risk and cost to the customer, provide that critical affordability in achieving their missions. Those are being spread across our portfolio broadly as we look at the next generation of opportunities and apply it, where possible, to existing programs as well. But that's not just in the way we execute our work, it's really in the way we manage the company. That agile digital transformation is part and parcel to everything we do, in the way we execute our work, the way we oversee our work, the way we manage the business and a critical evolution, both for our industry and then specifically for the company these days that we think creates that long-term affordability, that long-term efficiency. So we look not only to be the innovator and leading-edge design and manufacturing company our customers rely on but also to do so with the efficiency that's so important in this environment.

And one thing I feel like doesn't usually get billing at this high -- this early in a conversation when it comes to you, but I know it's very important to you, though, is talent, another ingredient to creating those optimum outcomes. So can you talk a little bit about now what changes you've made to the talent process, human resources, benefits to address various demographic and recruitment and maybe retention? I would say -- I wouldn't say challenges, but address demographic recruitment and retention goals at this point.

Absolutely, Jon. We have been very focused on growing the organization, both at top line sales but the workforce needed to support the growth, and last year, created an environment where we had to shift quickly to more of an online recruiting model than we had used in the past. And our team, because we are operating as an agile enterprise, was able to make that pivot quite rapidly, and we still met our hiring goals for 2020. And they were very robust hiring goals to bring on more than 12,000 new people in a calendar year where many people were not stepping foot outside their home and a good portion of our workforce was working from home. It was quite a feat. And we did that because we have been, for a long time, focused on teams of resources that help us to reach out not only at universities but in the professional workforce and have good avenues to reach talent through social media as well as the ability to bring those talent in -- bring that talent in and meet with our team virtually, and that allowed us to keep going last year. I would say retention for our organization is very much rooted in our work on culture. We have an inclusive culture at Northrop Grumman that attracts people to our company. It also helps to retain them. And we have seen attrition rates lower than industry average and expect that to continue based on the good work we're doing to support a work environment where people want to be.

Indeed. And obviously, you take those people and you use that, as you mentioned, to grow the corporation. So let's talk a little bit about growth now. You mentioned earlier that you expect to grow in a variety of budget scenarios, let's say. I guess, it comes down to the question of, yes, I mean to what extent is the DoD budget really an appropriate proxy for growth? It seems like it's not, but just given that backdrop, where do you see the most and least growth over the next few years? For example, what are you emphasizing and, perhaps, what are you deemphasizing in this market?

I think you're right that the top line growth is not necessarily a proxy for what any individual company will experience over the next 5 years. We expect that areas like space will continue to rapidly grow. We have seen double-digit growth in the space business at Northrop Grumman, and it has been the fastest-growing segment of the U.S. Department of Defense budget the last few years. If that continues as we anticipate, our portfolio is well positioned to take advantage of that continued growth. Other areas that we expect to continue to be at the centerpiece of the future are Mission Systems modernizations. That's everything from helping platforms to communicate with one another and share data, and we have a robust communications business, to the sensors that go on those platforms and collect data that allow us to operate in the high-end threat, as I was talking about earlier. Some of those modernizations are already happening on existing fourth-gen and fifth-gen platforms in the air domain as well as in the space domain where just about every mission area is being recapitalized to address a more resilient set of space capabilities. So those areas of both the platform and Mission Systems are expected to see growth over the next 5 years. And within our portfolio, we have been positioning for this transition for a number of years. We're not doing this in reaction to what we expect to be new priorities set by the Biden administration. These have been threat-driven assessments that we've made and have been on a journey to create the portfolio and the technical capabilities through the investment that Dave was outlining to position us for this future.

And then a dynamic of your growth story is also international. The new administration has put a pause to review some exports. Not a huge impact on your business, if my memory serves. But overall, how do you expect the administration to approach international sales? And what is your outlook? What is your outlook for the opportunity there, a market you've historically been underpenetrated on?

We absolutely expect the Biden administration will embrace allies. And much of our work in the international space is with our closest allies, and we expect that will continue. There will be, I think, a new lens on the Middle East, and in particular certain weapon systems, that have been put on pause, and those may or may not get ultimate approval. I think that will evolve over the next year or 2, and we'll watch that closely. But to your point, the Northrop Grumman portfolio has very limited exposure in those class of weapons and also to the Middle East region. Most of our work is in Asia Pacific and Europe, and we expect that it will continue to be so.

Okay. You brought up in the previous answer regarding growth this idea that you see growth in both platform and in systems. It sometimes seems like within the defense industry, there's almost a spectrum of you have a platform -- it's not a clean spectrum, but it's a spectrum. You can provide the platform or you can -- and/or you can provide the systems that enable that platform and empower that platform. Where does Northrop Grumman fall in that spectrum? And where do you see the most attractive return opportunity, let's say, over the next decade? Because it seems like a lot of the value is going into those enabling systems, and the platform just is "just the platform."

Well, I think that's the beauty of the Northrop Grumman platform portfolio is that we sit across that entire continuum. We can build platforms, and we do, particularly in the space and air domain, but we also can put Mission Systems in those platforms that allow them to work together, be effective in mission, whether that's lethality or access, and provide the data that's so important, not just for that platform but the others that interoperate with it. And the ability to cover that entire spectrum means that we create value by linking and integrating. And that creates a competitive differentiation that allows us to be more successful in winning work, but it also creates more value to the government because that integrated system where we are working in the company to create value is often more affordable and also is allowing us to capture reasonable returns for our shareholders.

So -- no, that makes a lot of sense. And now we'll also speak to this next topic, which is more focused on margin. What are some of the key drivers behind segment margins going forward? You mentioned earlier that there are investments to be made. There are some new programs ramping up. There are also synergies to be had. So how do you see the overall mix in the company when it comes to -- or how do you see the drivers of the company when it comes to margin over the next few years?

Jon, I think you've touched on a few of the key drivers in the question. Certainly, margin dollars and rates are both areas of focus for us. We were pleased to deliver an 11.4% segment operating margin rate in 2020 and to be able to project through our guidance an 11.5% to 11.7% rate in '21. That expansion is even in the face of some of the mix shifts that we've been signaling for several quarters now with more new programs, more of that new backlog growth that we've been pleased to deliver over the last couple of years, resulting in a greater percentage of cost-type development work. We've been about 50-50 between cost-type work and fixed-price work over the last year or 2. We do expect that to shift gradually over the next year or 2 to cost-type, given the growth of GBSD in particular, some of the restricted space wins and other new business expansion that we've been talking about of late. With that said, in the '21 guidance, we've been able to more than offset that mix pressure through a combination of some of the other factors you mentioned. In addition to the divestiture of the IT services work, which was a strong margin for that type of work but a bit below our overall corporate average, we do expect a year of strong efficiency, strong program performance in 2021. We have lower pension costs projected in '21 than we experienced in '20. And the net result of those factors is the increase to the guidance of 10 to 30 basis points that I noted earlier. Going forward, we've talked about '21 a fair amount, and of course, that's the only year we've guided. As we think about what will impact '22 and beyond, it's the combination of factors we've spoken about. GBSD should continue to grow in 2022 and '23 based on current projections. That, too, would continue that gradual mix shift toward more cost-type work in that portion of the business. We'll look to continue to mitigate that impact on our overall margins through efficiency and execution excellence elsewhere. Over time, beyond that period, we'll see opportunities for the mix to shift back, for certain work to migrate from cost-type development work toward more fixed-price production work. We have a few large programs that will make that migration in the coming years. And that, too, should support long-term margin strength. Certainly, the dollars and rate are both areas of focus for us in margins, and we'll look to continue the strong performance we've projected in '21.