Northrop Grumman Corporation (NOC) Earnings Call Transcript & Summary

Now an area that has appeared to us to be a little bit weaker lately has been on the autonomous side, basically HALE Systems. That at one time was a really strong area of growth for Northrop Grumman. When you look at that now given what DoD budgets are, some of your export opportunities, how should we look at your autonomous business going forward?

Well, we've been signaling for the last 2 years that we expected that business to flatten and then begin to decline as Global Hawk Block 20 and 30s were planned to be retired. That retirement actually didn't happen as quickly as we thought. So in 2021, our HALE portfolio is performing more strongly than we anticipated. But we now, again, in the '22 budget submission see the Air Force intention to retire those Block 20s and 30s. And that will be a bit of a headwind for us next year. We have growing sustainment revenue as we have deployed Global Hawks around the globe and still have the Block 40s. We also have Tritons beginning to be deployed. But with that said, the sustainment growth will not fully offset the production and modernization declines as those platforms move more into a sustainment orientation than a growth mode. We do see other unmanned opportunities on the horizon. We're working on 3 programs now that could mature into more significant unmanned systems, but not of the high-altitude, low-endurance class. And so we see the space of unmanned systems evolving, and we're working to continue to play a key role.

Now I remember several years ago in this area, one of the things that was I think really looked at as an important foundation for the work of Northrop Grumman on Autonomous Systems was the architecture, in a sense, more than the platform perhaps. And that was viewed as something that could extend across not just the high-altitude, long-endurance missions, but other things as well. I mean are you -- do you see yourselves as having a platform that we should expect to see longer term some emerging growth coming out of this, the kinds of things that maybe you were just referring to?

Well, as you just noted, it's not just about the platform itself. We learned a lot about autonomy in general that we're applying to other classes of systems now. We also have learned a good deal in an architecture about unmanned teaming and how to get them to work together. And so these are technologies that we see being more relevant to the next class of Autonomous Systems. Our high-altitude, long-endurance platforms really were built to be very self sustainable. They are truly autonomous, not remotely piloted. They are meant to work really alone and unafraid to be able to collect large amounts of data and communicate that back. Now we're moving to systems that are, again, autonomous, but need to work together in a teaming concept and do that on a smaller platform footprint. And so these are areas of expertise that our company has and believe are going to be applied both domestically and I would say internationally as well. And we see this as a key focus area for the Air Force, the Navy and the Marine Corps in the U.S. And the Army now is talking about use of Autonomous Systems as assistance for their overhead surveillance and communication needs in ways that they haven't in the past. So we see lots of new interest in unmanned, and it will require a broad portfolio. Just like we were talking about our Space portfolio, having a small to large, exquisite to low cost, these are the kinds of product portfolio positionings that we're working toward in the company in our unmanned systems.

Now switching gears a little bit because several people have posted questions about this. This brings me back to discussions you and I had many years ago actually, and that's in cybersecurity, which I -- something I know you're very deep in. Given all of the attacks lately, how does Northrop Grumman think about its position in helping to address those attacks? And then also, is this an area where we should see some substantial growth?

We do expect to see growth in cyber. And I would look at it on a whole of government perspective, not just from the Department of Defense, but from the intelligence community, the Department of Homeland Security. And even the Department of Justice and FBI are getting increases to be able to help address this as a whole of government issue. And what we think of is 2 dimensions to our cyber strategy. One is the customer-facing support that we provide, and that's to the intelligence community and the Department of Defense largely. And we do that with advanced technologies that allow them to operate in cyberspace both defensively and offensively. When we think about the Northrop Grumman portfolio, of course, that's just the defense mission. But we use that expertise that we gain from working so closely with our government and understanding the threat vectors that adversaries might use against our company and also the technologies that they seek to get access to. You might guess that we saw a good bit of activity after we won the B-21 program with nation-state adversaries trying to understand what we were building. And so our defenses are layered. They're deep. We invest significantly in being able to have our own forensics team to be able to analyze those threat vectors against our company, but we also rely on information exchange with our defense industrial-based partners and the U.S. government to support our defenses.

One -- okay. We've seen the budgets this year, past few years for cyber, at least what we can see kind of in this mid- to -- some of that maybe high single-digit growth. But one of the concerns we've had is that oftentimes, that money is spent on filling a lot of open positions, and there are many of them within the DoD and the intelligence agencies. So I'm wondering how you think about these budget increases translating into growth for Northrop Grumman.

With the increases that we see in this budget in RDT&E, some of that is going to classified technology development and some of it is going to manpower. But what I would say about how the department and the intelligence community have been addressing cyberspace is a very integrated approach to manpower both in the industrial base and the government working together on collaborative research and development. And I see that as positive because to the point I made, it's not just about the technology. It's about having the skilled expertise to be able to use that technology and operate real time in cyberspace. And that is the domain of the U.S. government, not the industrial base. And so that level of cooperation and the increase in budget to support manpower as well as technology needs to happen in tandem.

I want to ask you a question that -- well, I have to ask you, it's almost impossible. But -- so for all of us out here in the investment community, we're looking at -- when you look at Northrop Grumman, you see 30-plus percent of the revenues in classified programs. How would you suggest that we look at that? How can we assess this and get a picture of where the company is going to go in these classified areas?

Well, the first thing I would look at in understanding that 30% of our business is classified is that we're working on the things that the U.S. government wants to protect because they are so core to our national and economic security. And so we are honored to be chosen to work on some of those most important technological advancements that keep our company both safe and economically secure. Then I would look at how do you get comfortable that we're managing that part of the portfolio that an investor doesn't have the same level of transparency into that you may for the rest of our portfolio. And I would tell you, we manage it exactly the same. It -- we have our Board cleared. We have our auditors, external auditors cleared. And of course, our management team conducts the same level of programmatic reviews, if not more, for some of those really key strategic programs and the same level of broad enterprise support to their execution as we would to our unclassified work. In addition, we've been working with our customers, like you've seen on the B-21, to release more of their own assessment of that performance. And we've been really pleased with the partnership we have with the Air Force and their willingness to do that. We're not disclosing anything about the programmatics of what we're building, but there's no reason to not be able to share some of the progress that's being made. And so we'll continue to do that in partnership with our customers where appropriate so that we can have those disclosures. But the important thing to remember is we're reviewing risk and opportunities with the same rigor on those programs. We're reflecting them in our estimates that complete, which get reflected into our financial outlook. And so to the extent that we anticipate realization of a risk or opportunity, we are fully disclosing that in our financial reporting just as we do in other parts of the portfolio.

And should we expect over the next few years or do you expect the classified portion of your revenues to grow more rapidly than the rest? How do you think that will -- we're going to see a mix shift, I guess, to even more classified revenue.

We've seen that mix growing the last several years. But now as we look forward, we expect it to stay in that 30% range because we have some large lesser class, if I'd call them, programs like Ground Based Strategic Deterrent, Next Generation Interceptor, Artemis in our NASA portfolio. And these offset the growth that we're also seeing in our restricted portfolio keeping that mix around 30%.

Okay. Now another area, not classified. It's international, I think about 15% of your revenues today. How do you view that evolving? And your -- in a way, I think of Northrop Grumman a little different here than some other defense companies in that you have some sort of large, lumpy programs like the Triton or an E-2D that are international. How should we think about growth there with -- is that 15% about right where you're going to stay? Or what do you think on that?

It is about right. We have been growing the domestic portfolio nicely. And so growth in international, that's happening alongside and at a similar rate is what we would expect to see over the next couple of years. We have a number of programs that simply aren't exportable. We are working the Ground Based Strategic Deterrent. Many of the space programs that we have and the B-21, none of which would be open for an export market. So in the portions of our portfolio that do have the ability to be exported, we're getting great traction in the international market. And you named a few of them in our aeronautic sector. But in our Mission Systems sector, we have over 20% of the portfolio is international, and we see continued opportunity for growth there. So we are confident that international budgets remain solid and would support the kind of growth rate that we're seeing domestically. We just are seeing such a nice growth rate on domestic programs that are not exportable that we don't see the international mix growing on us.

So when you look at this profile, which it's very good news to have all of these growth, all of these large new development programs. But when you put all that together, a concern one might have is that you've got a lot of development work could be a lot of cost plus work, lower margin, you have maybe some risks associated with that. When you look at this profile, it's great to have this development and eventual production growth trajectory. How do you think about margins in the nearer term?

So I would point to a couple of things. First of all, these development programs are cost plus. So the margin exposure that we see on those is significantly less than what we might see on a fixed price development program. The other thing that I would point to is we've been working this mix shift since 2016 when we were awarded the B-21 and just continue it with new awards in Space and Mission Systems, et cetera, and have continued to deliver solid margin rates. Our Space business is, despite all of the growth, performing at margin rates that we consider best-in-class in the industry when you look at peers and their Space business performance. And our Mission Systems business, even though it's been growing mid-single digits and has been bringing in new development work, has maintained a margin rate. We're guiding 15% this year. So these are really healthy margin rates while having this mix shift that's been occurring for several years. And we've been doing that through strong performance. And the third area that we continue to work and we see further opportunity for in the future is internal cost reduction. Through our digital transformation, we're not just innovating in the way we deliver products using digital technology, but also in the back office, which is allowing us to drive efficiencies into the business and improve margin rates. So last year, we delivered segment operating margin rate of 11.4%. And even with all of the growth in development this year, we've guided to 11.5% to 11.7%. So seeing some margin rate expansion.

Well, another thing that we thought was very significant that you've done has been the decision to exit some businesses. And so your federal IT and Mission Support Systems business, you've sold off. You've been -- there's the exit from Lake City. Can you talk a little bit about what has led you to make these moves at a time when some other people might be saying, "Well, the budget is slowing, maybe we need to do some acquisitions." I mean how do you think about that process?

We want to make sure that we're aligning our investments to the highest priority parts of our portfolio where we see long-term value creation. And for us, IT services was not an area that we expected to continue to grow and with our focus in other parts of the market wanted to divert that investment elsewhere in the portfolio. Same was true with munitions, particularly small-caliber munitions. We put a bit forward on Lake City, but we did not want to invest significantly in that business. And so we weren't chosen to continue that work. And now as we look at the '22 budget and the outlook for munitions, it looks like that was a really good decision. So we look ahead. We try to understand the best we can where budgets might be going, what technologies will be most differentiating. We align our investment to those. And if we aren't going to invest in the business, we want to get value for our shareholders by exiting or selling that business in the most beneficial way, and that's what we've been doing.

And just to clarify, the exit from the federal IT business, the services business really has nothing to do with some of the much more sophisticated IT work you do in cyber?

That's right. We retained our cyber business. Anything that was about technology development, we retained. What we sold was IT services. So working with our customers to use those technologies and apply them. And our IT outsourcing were all included in the sale, which is a fantastic business, by the way. We just determined that we were not the right owner in that we weren't going to invest there in ways that would take away from our ability to invest in technology development that differentiates the company for the long term.

When you pull all of this together into cash, I guess, a few things. I mean you commented before that you've been in a period of using a fair amount of cash for development work. You've obviously got some very big programs you're building up. How do you think of the outlook for CapEx right now?

So we continue to invest in the business. And when we look at CapEx as a percentage of sales, we have said that in '22, we expect that to start to come down, both a reflection of the business growing, but also a reflection of needing less CapEx to support the stand-up of new development programs. B-21 was a significant area of investment, GBSD in its first few years. We don't see programs of that scale going into the next few years that will require that same level of CapEx. So we're still investing in the business, particularly Space, Mission Systems, as I noted, where we continue to see growth in new programs, but just not at the same rate. And our cash flow is quite solid. And with our balance sheet being strong and not needing to do further debt retirement and also having a well-funded pension, we see a significant amount of cash that we can return to shareholders. And so that's what we reflected in an update to our capital deployment strategy in our first quarter call, that we expect to return the majority of our cash to shareholders through share repurchase and dividends over the next couple of years.

Okay. Well, well, very good. What I'd like to do to wrap up here, but perhaps we can finish with you just giving us a picture of where you see Northrop Grumman headed over the next 3 to 5 years and what your priorities are.

So when I came into this role in 2019, I had 3 priorities, and they remain the priorities today. The first was to align the business to grow in the segments of the market that we thought were going to be most relevant for the next decade. And that is lining up our capabilities to the threat environment that is really driven by large near-peer competitors. And so we've done that. The portfolio shaping that we've done with the acquisition of Orbital ATK as well as the alignment that you and I were just talking about with divestiture of our IT services business have positioned us to continue to execute on that strategy. It's led to a growing backlog and robust sales growth. And we expect that, that can continue even in a flat budget environment. The second key priority was to transform how we operate the company to leverage digital technology. And we are doing that. We talked about it on today's call both for how we deliver product to our customers, but also the back office and efficiencies that can drive margin rate improvement. And then returning capital to shareholders. So we have been investing in the business robustly over the last few years. And we've shown that we've put that capital to good work to be able to grow our backlog. And now we look to return more of that cash to shareholders as we enter into a flat budget environment, just as we successfully did in the middle part of the last decade, but while still investing in the priorities that will position us to execute later in this decade and beyond. So those 3 priorities continue to be our focus. Performance is the foundation to it all, and I'm really proud of how the Northrop Grumman team continues to perform.

Well, great. Well, with that, let's wrap it up here. But Kathy, thank you very much for joining us and hopefully, we can do this in person next year.

Yes. Thanks, Doug, for having us. Look forward to seeing you.

All right.