Northrop Grumman Corporation (NOC) Earnings Call Transcript & Summary

Kathy Warden, Chairman and CEO; and Dave Keffer, CFO. So this is an audience reminder. For you in-person, which field scan the QR code that said your tables and you'll be able to answer -- provide feedback to the company that we'd like to present here at the end. And same thing for you online, you should be able to answer the feedback questions as we go through. So please, please try and take the time to do that. So I wanted to turn over to Kathy and Dave. And Dave, if you want to go through the necessary statements and then, Kathy, I think you have some opening remarks you'd like to make.

Thanks, David. Good morning, everyone. Before we start, I just want to remind everyone that today's discussion involves forward-looking statements. These 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, David. It's good to be here with you in person this year. I just wanted to share a bit of a retrospect in 2021. The company performed very well in light of the COVID environments and the challenges that all industry faced, we were able to grow organic sales 3%. We increased our earnings at the segment level by 40 basis points over the prior year, and that's even with significant development work coming into the portfolio with new wins and new franchise programs that we added across 3 of our 4 businesses, which have a strong backlog and growth potential headed into 2022. We also saw strong performance momentum, programs continuing to execute well and the ability for the team to hire and staff to support that growth into the future. And then finally, we focused on capital deployment. A record year for us, returning $4.7 billion to shareholders through our dividend and share repurchase, and we have shared our plans to continue that focus into '22 and beyond. So as we look at the transition from '21 to '22, we have strong momentum coming into the year. We are aligned on a similar strategy to what we've been executing to grow the top line, return a majority of our cash to shareholders through competitive dividend and share repurchase and continue to grow our business by positioning our portfolio in the highest priority market areas for our customers. So that's a bit of a backdrop. And David, I'm going to turn it back to you because I know you have some specific questions.

So we'll start high level. The budget, fiscal '22, you have an authorization bill, no appropriations bill. Maybe how you did in the authorization bill, what that might mean? Is that actually manifests itself in what matters in appropriations bill, the risk from the continuing resolution in terms of extended maybe [indiscernible] in terms of guidance. And then what your -- we started to hear some things with regard to what fiscal '23 might look like in Europe, your interpretation of that?

Let me start with a description of the '22 NDAA. As you said, the authorization does include an additional $25 billion above the President's budget request. So for a total of $740 million for defense. And as we look at that budget, we saw a number of our programs have plus up and do expect that if those go into appropriations, clearly, there might be some programmatic shifts in where resources are allocated. But by and large, saw support for space programs, aircraft, our radars in Mission Systems. So it's pretty broad-based support for the Northrop Grumman program portfolio in the NDAA. We expect that appropriations will come at the end of this continuing resolution time frame mid-March. It could extend, but we're hopeful that it will be resolved in March. And as we look forward to '23, as you said, there are reports that the top line number for the President's budget is closer to $770 million or it's a little higher, about a 4% increase to over $740 million if that ends up being the appropriations number. Now of course, inflation is part of what's driving the need for a higher top line. And just to keep real spending in check, we believe that $770 million or even a bit higher would be necessary. So that's what we're expecting, but there will be many more details coming out here in the next month or so, those are in '22 and '23.

So digging in fully with portfolio and maybe starting from the growth side of things. So we obviously all focus on 2 specific programs, B-21 and GBSD. But I wonder maybe if you could touch on some of the other programs, whether it be IBCS, the Missile Defense side, NGI, some of the other programs may be below the level of the growth we've seen out of B-21 and GBSD that are going to drive things over the next couple of years.

Our growth has been very broad-based. So to the message of 2 programs are not driving our growth, although those are 2 very important programs that you note B-21 and GBSD. And we do see the nuclear triad continue to be well supported by '22 President budget as well as Congress. What we are seeing is that in space, about half of our growth is coming from GBSD and the other half is coming in many programs. So I won't list them all, but the category for national security space, where we've seen a number of new wins and growth on existing programs that is the biggest driver of our non-GBSD growth in space. Although NAFTA budgets have been growing nicely, and we are a benefactor of that on both the SLS program and more broadly, the Artemis mission to return to the moon. In our Aeronautics business, we have clearly not seen growth in the last 2 years. So we've talked about a look forward into 2023, where that stabilizes, and our growth there will largely come as we move into production on programs like B-21 as well as some new opportunities that are emerging, particularly in un-Manned Aircraft space, but also new opportunities in Manned Aircraft that we expect later in the decade as well. And then in Mission Systems, there, we've seen growth across all 4 segments in that business. And it's everything from modernization of radars, like what we're doing on platforms to be F-16 and F-35, radar production and development and then also in our computing networking business, which is now one of the fastest-growing segments of our Mission Systems business as we enable the Joint All-Domain Command and Control vision of the Department of Defense and provide enhanced computing power to enable connectivity of platforms.

So in terms of the growth profile, you kind of gave us a little bit of a hint with the free cash flow guidance. I don't want to initially get into the free cash flow of all the different drivers of free cash flow at this point, we'll talk -- touch on that later. But you have this profile where 2022, I think, is relatively flat on kind of a pension-adjusted basis, '23 grows a little and '24 grows a fair amount. So what does that say just overall about the underlying growth profile of the company over the next 2 years?

Sure, I can touch on that one. Over many years period, over a long-term period, we always anticipate the free cash flow growth would be a similar growth rate to our earnings growth. Over shorter terms, 1- and 2-year period, some of the other factors that we've described can influence the difference between those growth rates. And this is one of those periods where this year and next, we face continued CAS pension headwinds as we've talked about at this point. In 2024, where we really see the opportunity for working capital improvement to accelerate. And that comes from a combination of incentive fee opportunities, milestone payments on some of our large programs and where we rack and stack the working capital opportunity. We already would compare ourselves to the very best in industry metrics when it comes to working capital efficiency, we work hard every day to drive at that. We see continued opportunity, particularly in 2024 on the working capital side. That coincides with an opportunity for lower CapEx as some of the demands in our current portfolio and new business portfolio weighing a bit in 2024, which gives us an opportunity for further cash flow acceleration. So we're really upbeat about the double-digit CAGR we continue to see over the next couple of years on the free cash flow side. That's bolstered by continued sales growth, as we talked about on our earnings call. We do expect organic sales growth to continue and earnings growth as well. But from year-to-year, some of these cash flow nuances around the working capital and CapEx dynamics come into play as well.

But from a top line perspective, I guess, I mean, obviously, we don't know all the new pieces that go into that cash flow forecast, but it's fair to assume a little bit slower growth profile in '23 and a bit of an acceleration in ''24 relative to '23?

Look, we haven't guided on multiyear sales growth outlook. We'll provide that over time as we always do. Certainly, the opportunity exists for overall market and federal budget expansion in '23 and especially in '24. We see those same opportunities in our business. We're going to continue to make every effort to execute well and continue to take share and outgrow the market as we did in 2021 and as our guidance of 2% to 3% organic growth implies for '22. And speaking of '22, I think in and of itself, we see an opportunity for growth expansion and acceleration as the year progresses. We talked on our earnings call about anticipating less than 25% of sales in the first quarter. And a lot of that is driven by some of the temporal supply chain and labor market headwinds that we've all seen, particularly related to COVID in the last couple of quarters. So as you see that south of 25% start to the year, notionally, if you think of a 24% Q1 ramping up, then you'd expect the second half of the year quarters to be obviously north of 25% each. And really the inverse of what we and the industry experienced in 2021. And I think that's a reasonable expectation this year as Omicron and other COVID impacts weighing in the remaining quarters. We have appropriations in place as we've been anticipating later this quarter. The opportunity sets itself up nicely for growth expansion in the second half of this year, which we'd anticipate then to carry into '23.

So Kathy, you touched on this a little bit, but I want to focus on AS and the profile there. So I think it was a little bit surprising, the decline -- the extent of the decline this year, want to see what detail you can provide in terms of the buckets there, maybe restricted versus unrestricted manned versus unmanned kind of what -- how those are playing out relative to each other? And then you made some comments on the last call about what the profile might look like in '23? I think today you said stable, maybe some -- the stable mean flat, the stable mean it declines less, just what you can say with regard to '23 for AS?

So as we have been signaling for a couple of years, the strong growth rates, double-digit growth at AS, we've seen in the '16 to 2020 time period would start to level out and then even decline with some headwinds that we signaled around our autonomous platform, Global Hawk being retired ultimately moving into more of a maintenance mode out production. Triton reaching its production levels and plateauing and F-35 plateauing. We did climb the way up during that period and B-21 being relatively flat until we hit production. So those we have talked about for years. They just have come to fruition in these last 2 years, and that's what you're seeing. In terms of what we were doing about it is we saw some of these missions moving to other domains like space. And we have seen that growth manifest itself in space is why we invested in space. And I'll remind you, our aeronautics and our space business were together into late -- both got so big that we split them into two 2 years ago, but that doesn't mean we've stopped looking at our mission expertise and our ability to support those missions and follow those into the space market. We've been very successful in capturing them, whether you think about JSTARS recapitalization, which largely now is moving to space-based missions or the kinds of intelligent surveillance and reconnaissance that we are doing on autonomous air platforms that also now are more supplemented the space assets. So when you look at those 2 businesses together, they're performing quite nicely, still a healthy growth rate. But the aero piece of the business has experienced headwinds we've talked about. As we look forward, I have already shared some of the growth drivers that we will see in aero in the next couple of years. For 2023, stable means flattish. We're not guiding a specific number at this point in time. But for modeling purposes, I would look at that profile for aero being relatively flat '22 to '23.

Okay. That's great. You mentioned the F-35. So you took, I think, over $100 million in negative EACs on the F-35 in '21 around the rebased production profile. Can you talk about what exactly that entails in terms of the negative EACs? And where your production -- I know you have many different areas that you're involved on the F-35 [indiscernible] production and beyond. But talk about where you are from a production standpoint relative to the rebaseline plan, relative to where, I guess, Lockheed is from a production standpoint.

Sure. I can touch on that. So the F-35 program for us center fuselage production, in particular, is fairly unique among our programs in terms of its scale, fixed-price nature and high rate. And when you combine those 3 factors and you incorporate the influences of COVID, in particular, over the last couple of years and the impact that it had on labor and absenteeism, productivity, it created real challenges for large-scale programs that were fixed price at such high-rate production. So what we experienced and identified in the second half of last year was that we needed to modify the production rate on the program to ensure a smoother, better coordinated flows such that in 2022. We could increase the production rate at pace and achieve the longer-term outcomes that we needed to do on the program. And so that change in production rate influenced the EAC, the cost assumptions and the remainder of ot 12 to the lot 14. So fast forwarding to today, we're on track with our expectations as we kick off 2022. We're in the process of negotiating with our prime, the next multiyear block as they are to our understanding with the government. So a lot of moving pieces in that negotiation. We'll defer to them in terms of overall volume production over the next couple of years but certainly anticipate that we'll be in close coordination within this. We negotiate the remainder of that next block of multiyear.

And as we said on the call, to answer your question about where we are in the production, we are in lot 14 production and it's nearing completion of that within the next year.

Okay. Over on the space side of the house. So GBSD $1 billion source of growth last year, $500 million this year. Based on the program of record, when does the program level off, maybe before the transition from development. Just thinking about the longer term, we went through this kind of with B-21. We saw that -- we didn't see it, but we saw the numbers at AS in terms of big ran not leveling up. What's the profile look like maybe a little bit longer term in terms of -- based on the program record for GBSD?

So with GBSD, the program in development moves to a lower growth rate, even last year to this as we have talked about, about $1billion of growth last year, about $0.5 billion this year. We see growth continuing in '23, but again, at a smaller rate than we saw this year. And then it does level off for a couple of years before production begins to kick in, in the later part of the decade.

So '24, you should think about leveling in GBSD. Okay. . Just -- in terms of the margin profile for the company, maybe Dave, you bounced around kind of in this 11.5% to 12% range. Last year, you got some lift from the IT services divestiture -- volume, you've got program performance mix, all these things that every year kind of go into the overall margin profile. How do you think about those different moving pieces? This year, you guided to relatively flat from a segment basis, but how do you think about those pieces moving forward in terms of the margin profile of the company?

Sure. So -- we were really pleased with our margin rate performance in 2021. As Kathy mentioned, we were coming off from 11.4% segment operating margin year in 2020, we're able to deliver 11.8% in 2021. And an expectation that we would maintain that rate in our guidance range for this year is 11.7% to 11.9%. And while there was a modest lift from the IT services divestiture that wasn't a material change. If anything, we're able to overcome the headwind of the mix shift that we've been talking about for a couple of years leading up to last year with wins like GBSD and NGI expanding our cost type development work portfolio, we were able to offset that and then some in the tune of 40 basis points of the run rate expansion. . There are a few areas that we're looking to drive that continued strength going forward. You mentioned a couple of them. Certainly, digital transformation, making sure that we are as efficient as we can be in the way we're executing our programs, delivering our products and overseeing the business. Our customers have talked a lot about the digital thread that we've been innovators in leaving through the design, development phase within the production programs like GBSD, which are little travelators in that area. Broadening the use of those digital tools across our portfolio is an important element of our risk reduction, our cost and schedule efficiency initiatives. So execution remains a top priority for us as we expect. Cost efficiency across the rest of the portfolio is important as well. We're never going to rest on our laurels that we're always looking to incrementally improve cost efficiency in the way we operate the business. Certainly, in today's environment, we need to look carefully at our real estate portfolio and see opportunities there for cost optimization. And so when you add that to the digital transformation efforts and the ongoing efforts to drive efficiency in our overall operations of the business. We think, that will continue to provide stability and strength to our margins even as we have this year and next growth in the cost type of development portfolio. As you get to the middle of this decade and that pendulum begins to shift back and you see a bit of a shift towards more fixed price work, that should create an opportunity for margin uplift in the years to come. So the near term, though, we're really pleased with the stability of margins in the high 11s that we're able to deliver in 2021 and project in '22.

You touched on working capital a little bit in the question prior. But -- and you mentioned that kind of benchmarking against your peers, you do very well from a working capital perspective. So can you talk about kind of how you look at holistically net working capital? Where you stand today? What the opportunity is? How you benchmark it? Just...

Sure. Everyone's balance sheet looks modestly different.

Right. Concisely.

Keep you guys going to tell us in terms of figuring out exactly how to compare apples-to-apples. But when we look at the core elements of the great assets and liabilities as it relates to the operations of the business, and we pull out not operating that includes the methods with your inventory receivables on the asset side, your trade payables or advanced payments on the liability side. And you net those 2 against each other, divide that by sales. We look at that as a reasonable way to compare companies across the industry and across their industries as well from a working capital efficiency perspective. And for our own metrics, those -- that percentage of sales has come down from the 9% and the 8%. In 2021, we delivered a low 7s percentage of sales rate. So that kind of efficiency improvement is really tremendous, and we've compared that 7-plus percent rate to just about anyone in the industry. And everyone's out there driving for working capital efficiency. We're really pleased with the progress we've made in that area. And so we look to continue to maintain that very efficient level in '22 and '23. And as we've talked about, we continue to see opportunities to improve even from there in '24, in particular, because of some of the metric, global dynamics I mentioned earlier.

Okay. Any updated thoughts on R&D amortization? And is that going to get deferred? Is it not going to get deferred? I mean maybe what you're hearing in how you've gone about interpreting the impact relative to maybe what you've seen out of some of your peers in terms of what falls into that?

Sure. Certainly, I won't speak for others. We've been talking about at approximately $1 billion a year 1 potential impact if 174 would stay in place. We continue to assess detail of regulations that are in place today as well as our R&D cost structure to make sure that we are understanding all of that well. We've got top advisers and all such that we're working with. We continue to model to the situation, of course. But I think the first part of your question is maybe the most important part, which is what's the likelihood that this is going to be deferred or repealed. And to that point, we continue to be optimistic that we're going to see a deferral this year. It's a legislative priority for both sides of the aisle, and there are many of those with such bipartisan agreement. And clearly, we'd be unique among large, developed countries in the world in having change to R&D amortization policy for tax. And so we're optimistic this is going to get resolved. It's really now just a matter of what the legislation can be tied to and whether that is some form of [indiscernible] as was originally anticipated or whether it's attached to other legislation elected to pass this year for tax extenders package late in the year. So we're certainly keeping a careful eye on that and making sure that legislators are as well informed as possible about the dynamics and monitoring it closely in terms of our tax payments in the meantime.

And capital deployment. So you have balance sheets in great shape. Let's say, R&D amortization doesn't get deferred, you have that headwind. How are you thinking about capital deployment potentially using the balance sheet to supplement your levels of free cash flow in terms of returning cash to shareholders?

Do you want to go with it?

Sure. So we've really delivered a healthy volume of cash back to shareholders over the last 12 to 18 months in 2021, as we talked about. We have been targeting $3 billion of share repurchases and ended up well north of that at $3.7 billion with the $500 million accelerated share repurchase in the fourth quarter, really adding to the volume we were already on track to deliver. That's on top of $1 billion of our dividend program. As we entered this year, we're going to continue to deliver a healthy return back to our shareholders. If that dividend volume continues, we look to maintain a competitive dividend. We've increased that for many years consecutively. We have another opportunity to evaluate that in the spring. On the share repurchase side, we've committed to at least 1.5 billion of share repurchase volume this year. And so whether 174 remains in place or not, we anticipate that continued strong volume with shareholder returns. If 174 is deferred or repealed, that creates additional opportunity and flexibility for us beyond what we've committed to, to date. And over the next couple of years, you shouldn't expect us to maintain the volumes of excess cash that we have over the last year or 2. We had $3.5 billion or so in a at the end of 2021. We anticipate that coming down to more historical levels in the $2 billion range over the next couple of years. And so particularly if 174 deferred or repealed, that would imply a larger volume of shareholder returns in the process.

Okay. I don't know, Kathy, do you want to add anything to that?

I simply talked about this at the beginning. We're committed to returning the vast majority of our free cash flow to shareholders. We started that deployment last year in a significant way with the $4.7 billion that we've talked about. And as Dave says, if 174 is deferred, it gives us additional flexibility this year. But even without that, we are committed to significant return of our free cash flow to shareholders.

Okay. We have a couple of minutes left. Are there any questions in the audience? Okay. Can we see if we can pull up the results of the audience questions? All right. So...

I like it, that is longer -- there were more than 1...

Exactly. All right, we could just keep -- all right, we can get...

Excellent. If we can move that one. Good.

Good. Okay. That's it. All right. Well, we're out of time. Kathy, Dave, thank you very much. Thanks for supporting the conference this year.

Thanks very much, David.

Thank you.