Northrop Grumman Corporation (NOC) Earnings Call Transcript & Summary

Okay. Good afternoon. Welcome back to the aerospace defense track at the 2022 JPMorgan Industrials Conference. I'm Seth Seifman, the U.S. aerospace defense equity analyst. And we are very grateful to have with us this afternoon, management from Northrop Grumman, and we have Dave Keffer, CFO; and we have Todd Ernst, who does IR and Treasury. And welcome, guys. Thanks for being here.

Thanks for having us.

Thanks for having us.

Sure. I think Todd is going to kick it off, and then we'll go to Dave and he'll kind of set the scene for us with what's going on at the company, and then we'll dive into some Q&A.

Great. Thanks, Seth. Good afternoon, everyone. Today, we're going to make some forward-looking statements, and those statements involve risks and uncertainties, and information about these risks and uncertainties can be found in our SEC filings. And with that, I'll turn it over to Dave.

Great. Thanks, Todd. As Seth mentioned, I'm Dave Keffer, the CFO of the company. A couple of introductory comments just to baseline everyone's understanding of the business in the current market environment, and then I'll hand it over to you, Seth, for further questions. 2021 was a really strong year for the company, and we were pleased to deliver 3% organic growth in the year. We delivered 40 basis points of segment operating margin enhancement even with a growing base of cost type development work from the large new program wins we've had in recent years. So we're proud of that excellent P&L performance. We also generated strong cash flows, combined with the proceeds from the divestiture of our IT services business that strong cash flow enabled us to deliver $4.7 billion back to our shareholders during 2021, including about $3.7 billion of share repurchase activity, demonstrating our continued commitment to return cash to shareholders. That was at an average price of about $344. So we believe we created strong economic value in the process. We start 2022 on a strong footing. We continue to project 2% to 3% organic growth in our guidance for 2022 as well as stable and continued strong segment operating margin rate, consistent with last year's level, 11.7% to 11.9% for this year and strong earnings and free cash generation ongoing. And we've provided now 3 years of free cash flow outlook with a double-digit CAGR in free cash generation from '22 to '24. As you can imagine, this is all predicated on an increasingly strong budget environment, both domestically and internationally, and we'll talk more about that, I'm sure, over this 40 minutes. In the very near term, a lot of focus has been placed on some of the temporal headwinds around supply chain and labor disruption associated with COVID. We're optimistic that this will be a year where those headwinds ease as the year progresses on top of the new budget that's now been passed this spring for fiscal '22, ending the continuing resolution. Those temporal headwinds, I think, will be more and more manageable as the year progresses. We've even seen through this quarter to date, that the Omicron-driven headwinds around productivity and absenteeism have eased a bit as the quarter has progressed as you'd expect, given the broader COVID environment. We anticipate similar easing of some of the supply chain challenges that our industry has been dealing with over the past year, again, as 2022 progresses. So we've told our investors to expect this year is unlike last year, where we were growing more rapidly on a year-over-year basis in the first half of the year than the second. We anticipate this year to be a year where organic growth on a year-over-year basis improves throughout the year. And so the first quarter may look more like 24% of the full year guidance range, improving to 25% and 26%, as you'd imagine, as the year progresses. And that type of growth trajectory for the year is consistent both with the broader demand environment and the current view of the supply side of the environment as well. When we talk about the broader demand environment, clearly, there's a lot of near-term focus on the events going on in Ukraine and the international tensions that are ongoing in the process. Certainly, we'd like to focus the discussion on the medium- to long-term environment, the threat environment and the resulting budget trends that we anticipate as a result, where we have a view that the defense budget environment is strong and getting stronger. Even in the last few months, we've seen a bolstering of the support for and then the final passage of the Omnibus bill for 2022, at a level over $740 billion for the Defense Department. The President's initial request was $715 billion, so substantially above that level. And then the initial discussion, the talk of 2023 budget outlook for defense is strong as well, such that we are hearing folks on both sides of the aisle support the idea of real budget growth for defense in 2023 on top of the impact of inflation on the department. So I think all of that is bolstered by the threat environment, which continues to be the driver of the long-term demand environment for our business, independent of changes in administration and congressional leadership, et cetera. As far as the priorities then within that budget, we continue to see that the near peer threat environment is the pacing environment of the next decade and beyond that the leading-edge technologies around strategic deterrents in the nuclear triad, around operating in a nonpermissive environment such as those that China and Russia and other near-peer threats would create are what guides our Defense Department these days in terms of its investment decision-making and the types of programs they'll prioritize over the next decade. We feel very well aligned to those priorities at Northrop Grumman. We support as a prime, 2 legs of the nuclear triad and are supportive of the third as well. We have a large space business that's been our rapidly -- most rapidly growing portion of our business, continues to see ample growth opportunity going forward in 2022 and beyond. In our Mission Systems business as well, I'd note the types of work they're doing around networking and communications, cyber and other sensing mission systems, I think, are on the leading edge and very consistent with the programs of the priority in the government these days. So overall, we see a healthy environment and a very well-aligned portfolio to continue to address that growth environment. So with that, I'll hand it over to you for any questions.

Great. Excellent. That was a great lay of the land, kind of touched on everything, but didn't really preempt my question, so I'm grateful for that. But you did touch on a number of topics that we'll get into. And maybe I'll start off with a couple of questions, and then we'll go out to the audience. I guess before maybe we get into the budget outlook and current events, you talked about the impact of COVID and supply chain challenges on the company. And I think a place that we probably saw that most over the past 2 quarters is F-35. And so can you talk about the impact that COVID has had on that program? And where things stand in terms of recovering to the pace of production that you guys expect without kind of surprises there?

Sure. So the F-35 program for us is our large-scale, high-rate production program that's fixed price with a large Northrop Grumman labor content in it. And so as a result, has a set of challenges in an environment where there are productivity and absenteeism issues like COVID has created for ourselves and many other companies. We experienced those in the form of EAC changes in the second half of 2021, as you mentioned. Those were driven primarily in the fourth quarter by a change in the production rate that we deemed necessary to smooth out the production flow of the program and then reaccelerate that rate in a couple of intervals during 2022 in a better environment for labor with less absenteeism and more productivity. That's the type of environment we've now seen bearing itself out over the last month or more as Omicron case rates have waned, productivity levels have improved and the opportunity exists to really get back on that solid footing on programs like F-35. So there are other programs where we can talk about other elements of the supply chain, but for F-35, the majority of the emphasis in that program to getting it back on the right footing in recent months has been on our labor. And that's what we feel confident about in a more manageable COVID environment.

Okay. Okay. And then when we think about outside of F-35 and whether it's labor or materials and things like chips and thinking specifically here about Mission Systems, how have things progressed there? And I guess, maybe you mentioned the fact that these headwinds would proceed as we move through the year. And so to what extent should we think about them still being present, let's say, in the first half?

Sure. These broader economic effects, particularly on our supply chain that were perhaps borne out of the COVID impacts, but are not any longer strictly tied to COVID case rates are not going to go away at a moment's notice. I think they took a longer time to arrive and they'll take a little longer to wane as well. And that's why we see the year progressing as it does. And I think some of our industry peers do as well. We've seen pockets of challenge on the supply chain side, areas like semiconductors, logistics and shipping have been pockets of particular challenge. Certain commodity areas have been a challenge as well. But I give a ton of credit to our team. We've done a great job of mitigating those to every degree possible in managing those impacts on our programs and on our delivery dates and milestones and therefore, on the mission success of our customers. We have a careful eye on the inflationary environment these days. Our business in our market have a better ability to insulate themselves from inflationary pressures than some other markets do, but it's certainly something we need to continue to focus on and mitigate and manage every day. through contractual work, through negotiations with our suppliers, maintaining fixed price arrangements with our suppliers where we have fixed price arrangements with our customers, repricing those programs on an annual basis where possible and other contractual means. So this is an environment that continues to evolve, but we are optimistic that it will improve throughout 2022.

Okay. That's an interesting comment on inflation. I guess the thought process is usually that defense is somewhat protected because a lot of costs are passed through, and that's true. But there are sort of -- there can be differences in timing and there can be multiyear agreements. And so I guess, to what extent have you had to kind of dust off the playbook that maybe people haven't been familiar with for a very long time in terms of making those arrangements and making sure that the margins are protected.

That's a great question, a great point because we haven't been in an inflationary environment like this one for many years. And so it is different in terms of the priorities around negotiation with our customers and our suppliers than the environment we've been in, in recent years. And that's not to say those negotiation environments have been simple or straightforward in recent years. This just adds a different challenge than those that we've dealt with in other environments. And so it is a playbook that we have been quick to dust off and be very diligent about in recent quarters. And the situation varies contract by contract, material by material or supplier by supplier. But in all cases, we try to manage our risks, mitigate our risks to every degree we can. Certainly, that's a more straightforward exercise on cost type business, to your point, than on fixed price business. Much of our fixed price contract portfolio is repriced annually. For those programs and others that are repriced less often, we work to have contract clauses that enable things like price adjustments, if inflation reaches a certain point or reopeners under certain conditions. So these are the types of tools available in our industry to mitigate risk associated with inflation, and we're doing everything we can to do so.

Okay. If we -- I guess if we turn to the budget, Congress finally agreed on an appropriations package for fiscal '22 last week. Is there anything you'd highlight in terms of -- for Northrop Grumman, in terms of where things came in any differently than you might have expected?

The budget that was passed, the Omnibus that was passed in March was, I think, in line with what we and others around the industry were hoping for and believed likely and in the government's best interest, but it was good to see it passed on a timely basis without additional CR passage that extended this further into the end of the first quarter or beyond. In terms of the specifics, we now have a defense budget for 2022 that's over $740 billion with incremental amounts in the form of supplementals associated with Ukraine support. There's some incremental COVID funding available as well. In terms of the specific areas of support that are most relevant to Northrop Grumman, we did see plus ups for some of our key programs. So the Triton program had 2 additional aircraft added, the F-18 program, where we're a key supplier, additional aircraft as well. We saw strong support for each of the legs of the nuclear triad, which are critical to our business. The space portfolio at Northrop Grumman was very well supported as well programs in the Mission Systems portfolio like SABR and G/ATOR, again, received healthy support in the final budget that was passed. The IBCS program, in which we received a competitive award for production in December, also well supported in the budget. So I think when you add all that up, you see strong support for the types of work that we perform for our customers. Leading-edge capabilities, innovative, high-end engineering work in support of the next-gen threat. And that is very well aligned with the priority set that we described earlier and the one that we think is better supported frankly, than ever domestically and internationally.

Right. When we think about the, I guess, the direction of budget revisions as we think about 2023 now is probably upward. And we think about there was an orientation toward peer competitors and toward China, especially, and the company is fairly well aligned with that. But to the extent that there are incremental dollars, now there's a different threat in Europe, which looks a little bit different. Does that -- does the emergence of that threat make it or the -- I guess it's always there, but does the fact that it's more pronounced now make it more likely that some of the legacy programs that might have been headwinds in aeronautics, for example, that maybe those wind up being a little bit better supported for a time?

I think time will tell on that front, and it's early to get too specific with an expectation. Broadly speaking, we believe that the trends that have been in place over the last year or more, and that we've expected to be in place over the next couple of years, will endure and that there will be trade-offs that need to be made. While there may be a strong and strengthening budget environment, there continue to need to be trade-offs in terms of legacy programs that are less relevant in the future theater than they've been in the past theater. And there are small portions of our portfolio that find themselves in that category. Again, we feel very well aligned with the areas of growth that will replace them. And I think it would be naive to think that the rising tide will lift all boats going forward, but rather that some of those trade-off decisions will need to continue to be made. The final timing may still be in the works, but we're focused on those next-gen capabilities regardless.

I guess in terms of those next-gen capabilities, a lot of them are in space. I was at a conference in D.C. last week and with some service chiefs and secretaries and there was a great deal of focus on space. I think the dominant growth driver in Northrop space business over the past year or so has been the GBSD program, and that's something we can all kind of look at on its own. But the rest of the portfolio has been growing fairly nicely as well. It's not always as easy to analyze that part of the portfolio because a lot of it is restricted. But can you talk about the capabilities that are going to drive -- putting aside GBSD, the capabilities that are going to drive space growth in 2023, 2024, 2025. What are the -- are there a handful of capabilities or programs that kind of stand out?

Sure. I can shed some light on both capabilities and programs because I think both are important in that regard. The growth that we've been generating in our space business and the growth that we project forward in our space business is much broader based than GBSD. And it's even much broader based than GBSD and the restricted portfolio that you mentioned as well. On the programmatic side, work like the next-generation interceptor is a critical missile defense program, where we've now been 1 of 2 down selectees for an important phase over the next couple of years. That's a critical long-term program for our customer set and a nice element of our growth engine these days. On the civilian side of space, the Artemis missions are a source of growth for us. The SLS contract award that we had on the booster side in 2021 as well as the HALO program, where we're developing a habitat and logistics outpost product for civilian side of space. I think are good examples of program growth that we have in that side of the space market, some of what we do on the national security side, we can't talk about. But there are other examples of growth there as well. And I'd point to 2 that have been announced just this quarter 1 called DA/RC, D-A-R-C, that is doing ground station work in support of the Space Force. Another called the SDA transport layer, Tranche 1, which added Northrop Grumman as a new awardee, having not been an awardee on the -- or a contractor on the Tranche 0 side. That's a nice growth opportunity for the company to serve an important mission for the Space Development Agency going forward. So these are all good examples in the unrestricted domain. In terms of capabilities, we feel really strongly about our ability to service a broad set of markets in space from the most restricted work to civilian work and even pockets of commercial work that are ancillary to the government space as well. And it's in capabilities, including missile tracking, which you can imagine in this era of focus on hypersonics is critical capability for the government. Our HBTSS program is an example of one of the important layers in that multilayered approach. ISR continues to be a key capability for the government as well. And then, of course, we haven't focused a lot on GBSD, but it is a multibillion dollar a year program that's a key leg of the nuclear triad and extremely well supported as we think about the budget environment and the overall political environment these days in its critical deterrence mission that I think the support for is clear these days.

Agreed on that. When we look at the investment that's been done in space, which I guess we can kind of see in the CapEx number that's disclosed every year, has most of that been for GBSD? Or is there a way to kind of just "back of the envelope" kind of breakdown. Is it primarily GBSD? Or has it been across the portfolio?

It's much broader than GBSD, but certainly, it includes GBSD. The growth of our space business has been in the double digits for several years now. And when you have a business growing that rapidly, that's a $10-plus billion business. Now projected in 2022 to be the largest segment of our business. Clearly, there will be some facilitization, some new tooling, incremental investment that comes along with that kind of growth to make sure we're well capitalized as we look to continue to grow and deliver on those capabilities for our customers. So GBSD has been perhaps the largest individual piece, but far from the only piece in what is a large and growing portfolio that has certain capital requirements in the process.

Okay. I guess the space is definitely one of the enduring requirements. When we think about the near term, we don't usually think of Northrop as a very short cycle exposed company. But when we do think about additional kind of urgent requirements perhaps related to the conflict in Ukraine, are there places where the company has exposure there?

The way I'd characterize that is we're prepared to support our U.S. and international customers, Europe, in this case, with certain capabilities, consumables and ammunitions and such, to the degree that those requirements need to be met these days in light of the conflict. But those are not a large percentage of the Northrop Grumman portfolio, to your point. And therefore, we wouldn't characterize that as a needle-moving growth opportunity for the company in the near term. What I think is more impactful is the medium- to longer-term opportunity that exists rising defense budget environment, both in the U.S. and as you point out, in Europe. Germany and other countries have been very clear about their intentions to invest more in their defense capabilities. We believe that will include opportunities for us to identify and pursue that further our support for a number of EU countries. The U.K. has been an important customer of ours for many years. And internationally, it's important not to forget the critical mission needs of Japan and South Korea, Australia and other countries outside of Europe over the next decade.

Okay. Maybe I'll just stop for a brief second here to see if there are any questions from the room. Okay. We'll continue. Maybe going back, we were speaking about space, and space is an area where we've seen a lot of new investment, some of it in the military side, some not. New companies coming to -- coming public, kind of more so than I can remember in my time covering the space kind of exciting. But where are the places where you see the most opportunity to partner with these nontraditional suppliers with startups is kind of accessing these places where there's new investment going on, an important part of your strategy, either in space or elsewhere in a company communications?

Yes, it is. We feel great about our own positioning in space. But we're careful to recognize that new entrants with new technologies and new ideas can offer innovative technologies and innovative solutions for our customers as well. And so teaming with them, finding opportunities for minority investments for strategic partnerships need to be part of our space strategy as well. And as we think about where the right opportunities for those types of nontraditional partnerships and investments and teaming relationships exist, it's primarily in parts of the space market that are -- that have overlaps with commercial markets. And so certain elements of the kind of proliferated LEO market, certain small sat capabilities, certain elements of the communications market, certainly launch services, these are areas where there are new entrants playing certain roles today that we think combinations with Northrop Grumman's capabilities, customer access and existing programs can make sense from a teaming perspective, and even from a strategic investment perspective in certain cases. And so we've pursued some of those to date. We'll continue to do so going forward. Companies like SpaceX and Blue Origin have been great partners to us. They're competitors at other times. And so we'll look to continue to avail ourselves with the right opportunities to work with companies like those as well as the much smaller newer entrants with mid-tier capabilities going forward.

Okay. I guess bring things back to the financials a little bit. You guys gave a long term or, I guess, multiyear outlook for cash flow on the last earnings call in January. Subsequent to that, we've seen a fiscal '22 budget that came in above -- we knew it might come in at that level, but it wasn't in the bag. It seems likely that fiscal '23 will be above what many of us were thinking at that time. What is that -- and then this is a long-cycle business where things take some time to get moving. So with higher-than-expected budgets in '22 and '23, what's the implication for sort of what you've already told us about cash flow in 2024. Does it create the opportunity to be in the high end or kind of above that range?

That's a great question and one we've been asked a few times today. I think the best way to characterize it is -- we feel really good about the growth rate implied by our '22 to '24 free cash flow guidance at north of 10%. We have a base case scenario that we're assuming there that's much broader than just a single budget growth assumption or a single company growth assumption or profit rate assumption. We have, as we talked about on our earnings call, assumptions around improvements in working capital that drive a portion of that free cash generation growth, especially in 2024 when we see certain opportunities for milestone-based incentive payments to be generated. We also have an opportunity based on our current outlook for greater free cash flow from lower capital expenditures in 2024, given the current set of program requirements and demands that we anticipate over the next couple of years. You mentioned GBSD. It's one of a few programs that we would anticipate that is at a peak level of investment today and over the last year or 2 that we anticipate lower volumes of capital expenditure by the time we reach 2024. So it's a fulsome set of assumptions that go into that math for '24 free cash flow outlook. I wouldn't point to a single change, whether it be to the demand environment, budget growth, et cetera, to dramatically change our thinking. We'll update you over time on each of those elements of the free cash flow outlook over time. But certainly, we feel good about the long-term impact that those budgets will have on the business.

Okay. Okay. Excellent. There's -- one of the questions I wanted to get into is not -- I don't think it's one that I've ever asked before, but it's about ESG. And Northrop has been more high profile, I think, than some others in the space and talking about ESG in recent years. You're a major defense contractor, so what does ESG mean for a defense contractor? And how can the company ensure that an increasing focus on ESG doesn't prevent as wide an array of investors as possible from owning securities, Northrop securities?

We talk about ESG, perhaps more often than others because we think it's the right focus for the company to have. We think it's a valid focus for our investors to have as well. And we're proud of our track record across each of the fundamentals of ESG. We've had dramatic reductions in our carbon footprint in our emissions over recent years. We're proud of the disclosures that we provide and that we continue to enhance every year around our environmental objectives going forward over the medium to long term. They have been a core element of the company's focus long before ESG was in particular vogue with our investor base. The same is true on the social side. DE&I initiatives have been a part of our -- the fabric of our culture for many years, and we're proud of our track record of improving the percentage of our population, our leadership population as well that are people of color, females. And we plan to continue to deliver on meeting new and stronger objectives around DE&I each year. We think it's the right thing to do, independent of the overall investor ESG perspective, it happens to be particularly well aligned with that perspective. From a defense business perspective, we're proud of the work we do and the missions that we support for the U.S. government and for our allies. In recent weeks and months, we've perhaps seen greater support than ever for the missions that we support. We're careful about the type of work that we do, and we've pruned elements of the portfolio over the last couple of years such as our biometrics work, cluster munitions, related work to make sure we have a better track record than ever from the perspective of our defense portfolio. But at a fundamental level, we're a defense company. We're proud to be one, and we're proud of the missions that we support on behalf of our customers.

And I'm curious, what kind of feedback have you gotten from U.S. investors on the topic of ESG? To be honest, it doesn't come up in a ton of my conversations with investors, but maybe if someone speaking to me, they're already -- they've already determined what their thoughts are about ESG.

We get very positive feedback from our investors about our ESG initiatives. We get a lot of feedback about the quality of disclosure that we provide, the fact that we include ESG in our incentive structure. We have meaningful nonfinancial metrics included in our annual incentive metrics. And they're, again, a part of the way we drive and incentivize behaviors in the company and the way we report externally. We get good feedback on all of that to include the work we've done around our portfolio as well. So -- we think of it as a differentiator in that way. But certainly, it's all formed off of the foundation of feeling like it's the right thing to do and the right way to do business.

All right. Is there -- I don't know if it's too early to tell, but is there a thought that recent events might prompt a change in the way that the market sees this topic? And particularly, in Europe, where I think it's a lot of defense-focused stocks had been difficult to invest in them?

It's early. I agree to generate a full view of this. But certainly, we are seeing some indications that investors that have in the past limited the number of defense-related stocks that they can invest in or at least rethinking that position, if not formally changing yet that position. We're optimistic that the emphasis being placed on national security and defense these days. And the criticality of the types of missions that we support, both for domestic and international customers will be better recognized than ever in this environment. And that investors who are particularly ESG focused, whether they be based in Europe or the U.S. or other parts of North America that they can get a sense that maybe a fresh perspective could be taken on that, on any exclusions of the past. Certainly, I think there's good reason for optimism around that. And a number of investors have already started to step forward and ease some of those past restrictions.

Okay. I'll stop for a moment here, just see if there are any questions out in the audience. Maybe if we go back to the portfolio. So unmanned capabilities, unmanned aerial capabilities are also going to be, I think, at the center of future, the nation's future defense efforts. And this is an area where Northrop has played an important role historically, but also where there haven't always been that many new programs where the company's capabilities at the high end haven't always been in vogue in terms of what customers are looking for. How do you think about the autonomous business within aeronautics evolving? And are there opportunities for that business to begin growing again once Global Hawk kind of resets? And are those opportunities more at the high end, at the low end or both?

That's a great question. The autonomous portion of the market is evolving more rapidly than it has in a number of years. Certainly, the aeronautics business is our longest cycle business. And so changes in growth rate don't occur overnight in that business. But certainly, in this environment, we see opportunities for long-term growth in our unmanned portfolio. Secretary Frank Kendall, of the Air Force has been clear recently about the priority around advancing a few particular programs that will deliver next-generation capabilities in the unmanned portion of the fleet that serve as accompaniment to fighters and bombers that are or maybe manned. And so that accompaniment, I think, can take the form of a spectrum of high-end to lower-end capabilities based on what the department has said. The higher-end capabilities would be more in line with our historical prime portfolio. The -- all the way toward the middle and lower end of the capabilities could continue to be candidates for us to participate in, whether it be as a prime or through our Mission Systems business, the future outlook and the specifics of those programs is to be determined, and certainly, we'll keep a careful eye on the government's requirements there. But we continue to see a bright future for opportunities in the unmanned and autonomous market. And we feel like our legacy and our positioning there are such that we have a good opportunity to be a key participant.

Okay. Very good. Thinking about capital deployment, the stocks, I think you mentioned earlier, average price of last year's repurchases was 3 40 or 3 44, and so about $100 higher now. But does that change at all the way you think about deploying cash toward repurchases now that the stock price is higher?

Shareholder returns and share repurchases are a key tenet of our cash deployment strategy. And we're not going to endeavor to time the market such that we always have peak levels of share repurchase activity in periods where the share price is suppressed. Certainly, that's among a number of factors that we consider, but it's a core element of our strategy to deploy discretionary cash back to our investors. We've committed to $1.5 billion or more of shareholder returns in the form of share repurchases this year on top of our competitive dividend program, and that remains our commitment. We continue to believe that's a core element of our strategy, our capital deployment and financial strategy in general. And in a business like ours that continues to generate healthy volumes of cash, we have the flexibility to deploy capital to our shareholders as well as continue to invest in the business and manage our balance sheet well going forward.

Well, you nailed it. I think the clock just hit 0. It's good timing. But yes, Dave, Todd, thank you very much for being here. We really appreciate it.

Thanks for having us, Seth.

Thanks, Seth.