Northrop Grumman Corporation (NOC) Earnings Call Transcript & Summary

Okay. Thank you, and good morning, everyone. Thank you for joining us here today. My name is Peter Arment. I'm the senior aerospace and defense analyst here at Baird, and we're very pleased to have with us the management team of Northrop Grumman Corporation. This is a fireside chat, but we do encourage anyone to submit a question via the web portal and if time permits, we'll certainly get to it. But -- and from Northrop Grumman, we have Kathy Warden, the Chairman, Chief Executive Officer and President; and Dave Keffer, who's the Chief Financial Officer. And before we get started, I'm going to pass it over to Dave, who's going to give us a forward-looking statement and then Kathy is going to make some opening remarks. So with that, Dave, welcome, Kathy, welcome.

Thank you, Peter. Happy to be here this morning, and 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, I'll hand it over to you, Kathy.

Thanks, Dave. And thanks, Peter, for having us virtually this morning. I thought it would be helpful to just spend a moment recapping our third quarter call. We updated our guidance for 2021 and provided some outlook for 2022 that will be helpful. In terms of our Q3 performance, it was another strong quarter at Northrop and we continued to deliver growth in the business as well as updated our sales outlook for the year to approximately $36 billion, which was the midpoint of our prior range. At the same time, we were able to increase our segment operating margin guidance and our EPS and maintained our free cash flow guide for the year. I'm really proud of the team's results given particularly the challenges that the entire industry saw in the supply side and labor market due to the pandemic. As we look forward for 2022 then, we expect to see continued growth in the business. We did share that 3 of our 4 segments were expected to grow in 2022. Mission Systems, Defense systems and of course, Space, which has been on a very strong growth run, which we expect to continue into next year. And we did note that our Aeronautic sector after a straight string of years of growth in '18 through 2020 was now seeing declines, primarily with those missions that we were doing in the air as expected, moving and migrating to space, and we've been able to capture those missions through space programs and continued to fuel the growth there. As we look forward then for 2022, we are continuing our strategy, which is to deliver growth, strong operational performance and return a majority of our free cash flow to shareholders. We've talked about that and really demonstrated our commitment to that after our third quarter call and now seen another ASR for $500 million, which will bring our total share repurchase plan for this year to over $3.5 billion. So that gives you a sense of what we've recently reported and our outlook for next year. And it's probably a good time to turn it over to you for questions, Peter.

That's a terrific overview, and it's a lot of good things going on and a good way to start off. So Kathy, I always like to start off with you on the big picture just because there's always a lot of changes in this industry. So we are 1 year into the Biden administration. Maybe you could just give us a little color on how your programs are lining up probably if there's any really shifting DoD priorities under the new administration?

As we look at the budget, we're very pleased with the discussions that Congress has been having. It shown strong bipartisan support continuing for national security and particularly in areas that are relevant to Northrop Grumman, areas like the triad or strategic deterrent. As I know the audience knows we are the lead on 2 of the 3 legs of the triad and participate on the third. So this is an important area for us. And both programs, B-21 and GBSD have been well supported in committee. We also have seen strong bipartisan support for advanced weapons like hypersonics. And I'm sure we'll talk a little bit more about that, but we have a broad portfolio of hypersonic weapon capabilities that we are offering through over 6 programs. And then in addition, Space, which has been one of the fastest-growing segments of the department budget. We see that continuing well into the future and has really been the foundation for our Space business to see over 20% growth for the last 2 years.

Great. One of the things that we hear a lot about kind of hard to -- kind of conceptualize the JADC2 kind of development. I think a lot of investors look to the budget line item and don't -- and can't find it in this. How this may line up? How you see Northrop participating in that priority going forward?

We're strong supporters that joint all their main command and control, primarily because it helps the Department of Defense link assets that they already have to share data and communicate with one another, and we see this is opening up a new way of operating in all domains and sharing information between domains. The way that's done is through open data standards and connectivity, and our company has long been supportive of providing the government the data they produce and that they should own and we do that on programs like B-21 as well as programs like GBSD, which is built with a completely open architecture and all of that data is going to be owned by the government as well as the technical baseline being owned by the government. We think this is the way forward. And our customers are responding very favorably to the decisions we've made to lean in on giving them the data and the open standards that they need to move forward with JADC2. We've also been a bit of a pioneer in some of the enablers for Joint All-Domain Command and Control, things like our BACN products, the battle airborne control network is a system that does exactly what we're talking about. It helps to connect assets that were never meant to communicate with one another through gateways in the air that allow ground forces and airborne assets to share information. And so these are good examples of products that are already in the market space that we are providing our customers. And as we look forward, we expect to be able to continue to provide them these types of capabilities. Now what I will say is I don't expect JADC2 to be one big program. It is a series of small programs. And these will unfold over time. It will be modernization of existing platforms. It will be products like I just explained with BACN, but it's not one big program. I think that will actually make this effort far more successful.

So sort of more of like a broad industry tailwind across the board on a lot of the areas that are getting refreshed. Okay. That's helpful. On the hypersonics, you mentioned it. So I'll ask, maybe it's certainly a hot area. Maybe how big is it for you? Or how should we think about how fast it's from any key milestones that we should be thinking about in this area going forward for what you can talk about?

Hypersonics is an important market for us. We provide propulsion, fuses, warheads. So many components of the weapons and we're doing that with multiple partners. As I noted, we have over 6 programs in hypersonics today, and they are across a wide set of technologies. We recently, with Raytheon, demonstrated our scramjet technology on the Hawk program and that test team successful in its first opportunity. The first one to provide a Mach 5 feed or propulsion of hypersonic missile. So we're really proud of that work that the team has done, and see that program having a bright future and of course, getting larger as we move into production in the later part of the decade. But we're also supporting other primes on their missile programs, including one for the Navy, one for the Army and 3 others. I won't go into the details of each of them, but it's broad based in terms of the services it represents, the capabilities that we're providing on those weapons. And as I said, it's growing for us as we're in development, but we see the majority of that opportunity as we transition into production on this program. And then I'd also be remiss if we talked about hypersonics and I didn't talk about counter hypersonics, which is also part of our space business to be able to detect, track and target those weapons from adversaries.

Is there a percentage of revenue that you think that you can disclose? Or is there better is in this area? And maybe that's something we can frame for investors going forward? Or how would you approach that?

It's small to start, so single-digit percentages today, but we see it growing as programs migrate into production, and it will be dependent on the quantities on those programs as well as which programs actually successfully traverse from development into production. But we like the broad base of our portfolio. So we're quite confident that several of the ones that we are enabling will make that transition.

Okay. That's helpful. One area that's not small in the percentage of revenues, but always difficult to talk about is restricted. 30%, I think, of your -- of Northrop Grumman's revenues comes in kind of this category in restricted areas. And obviously, it takes -- creates a challenge from a communication standpoint. But how should investors think about the outlook of this business going? Is it in terms of the growth of this portfolio?

So as you noted, it is 30% of our portfolio today. We expect it to be 30% again next year, and that's because the parts of our portfolio that are growing are both restricted and unrestricted. So in Space in particular, we announced in Q3 that we had $1.2 billion of new restricted awards. But of course, we also have GBSD and NGI that are growing. So it's a nice call to have the unrestricted and restricted or competing with each other to see which can grow the fastest, and I love to see that. But at the end of the day, our restricted work to me represents an important part of the portfolio, because it's a recognition by our customer that we are solving some of their most difficult challenges and it's technology they want to protect that they don't want to expose to others, so that they can copy it. In my mind, I mean we're working on the crown jewels of the country. And we're very proud to be entrusted to do that with such a significant part of the government spend in the restricted area.

It's a terrific way to put it. Certainly, the crown jewels. And Space, so you brought up Space earlier, I wanted to come back to that. I think it has been exactly a little bit more than 3 years since the Orbital transaction right around there. It's obviously a great strategic and financial fit. I know you were heavily involved in that transaction. So maybe just you could bring us up to date how that's going, how it's fitting in. It certainly feels like a 1 plus 1 equals 4 deal and just maybe how you're measuring that now? I know it's all integrated, but maybe just give us an overview of how that's all going.

Well, we certainly see it the way you do that, in that case, 1 plus 1 has equaled far more than 2. And at the end of the day, we looked at 3 areas of synergies for the deal that we expected to achieve. One was cost synergy and a lot of deals in our industry are built solely on cost synergy or primarily on cost synergy. For us, that was expected to be a smaller part of this opportunity. Orbital ATK was a lean organization, but we have achieved our cost synergy goals. We have laid those out to be achieved in the first 2 years, and we achieved them early. We also, though, outlined operational synergies, that's where we could migrate facilities and share infrastructure. Those projects take a little longer, but they're on track, and we're there too expect to exceed our objectives. And then finally, the most exciting part of the deal was the revenue synergy that we expected to get, both space and advanced weapons. And frankly, it has exceeded our wildest dreams in terms of what we could do in bringing together the Orbital ATK portfolio within Northrop portfolio. It's demonstrated in the growth that we've seen in the space segment. It's a little harder to see the growth in the advanced weapons segment, because it's embedded in our Defense Systems business, but it is real, and we see it in programs like AARGM-ER, where we were able to prime really for the first time missile program and set the stage for future competitions that we may also be able to prime in missiles. So we have seen broad-based growth and the restructuring that we did to put these pieces of the portfolio together in early 2020 have really demonstrated to us that while we have captured great synergy in the last 2 years, there's plenty more of opportunities to come.

So within space, I guess, maybe I'll just wrap it up into a kind of a more of a 2022 commentary and bring David in a little bit, but this is -- so GBSD is still showing a lot of growth going forward, but you also have, as you mentioned, you're transitioning with some headwinds on the HALO portfolio. Maybe you could just describe a little bit some of those moving pieces, some of the things that are really on the -- moving in the on the upside and then kind of how the HALO portfolio transitions?

Sure, Peter. I'd be happy to talk through some of those details. In aggregate, as Kathy mentioned earlier, we provided an initial outlook for 2022 that represents continued organic growth. In this case, based on our latest expectations in the low single digits in with the space portfolio being the fastest-growing part of our business, again, Mission and Defense Systems, both growing organically as well. And as we've talked about the Aeronautics portfolio declining at this point, our expectation being roughly in the mid-single digits next year. So starting with that portfolio, there are really a few factors that are driving that dynamic. One is that's the portion of our business. And I think of the market in general, that has been more impacted by the COVID effects on the economy and on our market than any other. The labor and supply chain influences on our air business have been more significant than the other 3 sectors. We talked about that in terms of its impact on the F-35 program on our last earnings call, and that's just an example. Second, I'd note that as a domain, we see some portions of the mission set moving from air to space. And in fact, supporting that space growth as we see mission sets and then programs specifically moving from air to space. And then some are more at a programmatic level. In Air, we've grown dramatically over the last 3 or 4 years, at a point in the portfolio life cycle in our Air business, where the growth is expected less in the near term now than it's been over those last several years. Examples of that would be the HALO portfolio, where Global Hawk in particular, we're seeing retirements coming up shortly of the Black 20s and 30s that was actually delayed a bit. This year, supporting this year further. We do continue to expect that going forward. We also have talked about F-18. The general flattening of the F-35 for our Aeronautics portion of that portfolio. And then our restricted portfolio is an element of the decline next year as well. So again, a series of factors, mostly just kind of temporal in nature and we're optimistic again about the longer-term outlook for that business. Defense Systems. So this year, we had the Lake City loss to overcome. Absent that loss, that business is actually growing in the low single digits this year organically. And so we're pleased with that trend and expect a growth trend to continue in 2022 for Defense Systems. Our Mission Systems business has been a solid mid-single-digit grower for us this year. We again anticipate growth for Mission Systems in 2022. And a lot of the growth opportunity there in addition to some of the programs Kathy mentioned earlier, SABR, BACN and other kind of staples of our Mission Systems portfolio. A lot of the growth opportunity in '22 is on the restricted side of that portfolio as well, and we're enthusiastic about some of the opportunities for expansion there. And then certainly, our Space business is expected to be our fastest grower. We've talked about GBSD growing about another $0.5 billion in 2022 on top of the $1 billion or so this year. And that's about half of the growth that we expect for our Space business in 2022. So there's ample growth elsewhere. The NGI program being a good example of that, the next-generation interceptor. We have several programs continuing to ramp on the restricted space side. So again, a really healthy growth dynamic where we're continuing to take share on the Space side of the business. In aggregate, an outlook that would call for low single-digit growth next year, and we're really pleased with the momentum in the business.

Yes. And so the -- if we think about margins, I mean, you're sort of a victim of your own success. You've won a lot. And so you're getting your development. That development mix is changing. How do we think about that? You sort of have some of the legacy programs rolling off, which you got some great growth and a lot of new programs, which is also exciting.

Sure. I think we have a great story to share on the margin side of things. In terms of segment operating margin, we finished 2020 at 11.4%. We started this year with an expectation of 11.5% to 11.7%. and we've since increased that guidance twice now to 11.7% to 11.9%. So significant expansion from last year to this year in 2021. A portion of the year-to-year expansion has been driven by lower overhead rates, in part supported by the lower CAS pension costs. And so as we look to 2022, we do have the dynamics you mentioned where we continue to ramp large-scale cost-type development programs like GBSD and NGI. But we're looking to mitigate a portion of that mix shift and the year-to-year challenge from not having the lower overheads associated with the pension cost reduction and in fact, mitigate that to the tune of a portion of that 20 to 30 basis-point decline from 2021 to 2022 that would have occurred just from the absence of the overhead costs. And in fact, mitigate a portion of that, and have a really strong outlook for '22 operating margin. And as a result, that would imply, again, well above the 2020 level and above where we started 2021. So really strong performance has led to that risk retirements, EAC improvements throughout '21. And again, those are implied in our 2022 outlook. So we're pleased us with the operational kind of execution strength in the business and expect that to continue going forward.

And then maybe just so that all rolls down through kind of the CapEx spend. Again, this was all the profile that you've had to invest quite a bit to build up and how we think about CapEx. And then Kathy mentioned that there's a big emphasis on returning a lot of cash back to shareholders and just how that rolls through on from a free cash flow standpoint.

Sure. On the CapEx side and the free cash flow side in general, we provided some initial indications of where we see that trending in 2022. We've talked for years about the fact that we would see CapEx kind of peaking as a percentage of sales in 2021, that continues to be our expectation. But the ramp down from this level won't be dramatic over the next couple of years. We expect a more modest decline as a percentage of sales. And so we indicated a pretty flat CapEx level on a dollar basis in '22, compared to '21. Among the other free cash flow drivers, we've had an outstanding 2020, a really strong '21, driven by additional working capital improvements. In '22, we anticipate a pretty stable level of program-driven, operationally driven free cash flow. As we mentioned, fairly stable from the '21 level. The 2 kind of nonoperating items that we have an eye on are the lower CAS pension reimbursement, which really represents kind of a continued purification of our free cash flow stream as those CAS pension levels have come down over the last couple of years due to really strong asset performance in our pension plans that removes that as a future headwind from our free cash flow stream. And then on the tax side, we expect modestly higher cash taxes in '22 than '21. So the fairly flat kind of operational free cash in '22, compared to '21 would then be affected by the $350 million or so of lower CAS pension reimbursement on the nonoperating side and then of significantly smaller impact from the lower -- the higher cash taxes in '22. So hopefully, that gives you a directional sense for '22. I think the best news that we're seeing on the free cash side is a real nice opportunity to grow free cash flow from there. As we look at '23 and '24, we anticipate double-digit growth CAGR for free cash flow in those years. So setting a baseline in '22 for a really strong free cash growth outlook from there, which gives us a healthy opportunity to continue to return cash to shareholders, as we've talked about being our top priority for cash deployment beyond this year as we've established already a nice track record through the ASRs this year that Kathy mentioned earlier.

I appreciate that, Kathy, maybe just to wrap up with the last kind of question around ESG. Just because it feels unfair that defense companies don't get asked enough about ESG, but I know that it's important to you. So maybe if you could give us a little just about a rundown from a Northern perspective on ESG, that would be helpful.

Well, Peter, thank you for asking because it is very important to us. And we have a track record of being quite transparent about goals that we set in the company around ESG. We have been setting diversity and inclusion measures in our business through over a decade. And our organization now looks like the communities we live and work in our representation and management really does reflect gender parity as well as the strong people of color representation inside of our workplace, and we're proud of that. We don't see that as a completion of our work in DE&I. We see that as the foundation for the work that we continue, and we are committed to maintaining that representation, but also building a very inclusive culture inside the company. In terms of environmental, similarly, we have had goals in place. We've been able to, over the last decade, reduce our greenhouse gas emissions by 44%, and we're proud of that. But the next stage of growth for us and our industry is to partner with our customers and ensure the products that we're building also are eco-friendly to the extent possible. And that really is a challenge within our portfolio, and it's one that we need to work jointly with our customer. And we at Northrop have put in place a Chief Sustainability Officer, who will lead that charge for us. And then, of course, as we look at our governance practices, we feel that for a long time, our company has focused on shareholder-friendly practices and transparency, and we'll continue to do that. And we're looking at our portfolio to ensure that it's a portfolio that investors would be proud to own and that even small pieces of it reflects our commitment to human rights and the work that we do to protect people's freedoms and deter conflict, not the contrary. So we're really proud of our record. But my key message is that our work continues, and we want to be a leader in our industry, and we're making the investments inside the company to make that happen.

It's a terrific place to leave off on. I appreciate both Kathy and Dave joining us today. And thank you very much for participating and then, hopefully, we can do it in person next year. But thank you again.

Thank you, Peter.

Thanks, Peter.