Northrop Grumman Corporation (NOC) Earnings Call Transcript & Summary

Hey, everyone. Thanks for joining our next session. I'm Kristine Liwag, Head of our Aerospace and Defense Research at Morgan Stanley. So I am pleased to have Kathy Warden, CEO of Northrop Grumman; and Dave Keffer, CFO of Northrop Grumman. So thank you, Kathy and Dave. Before we get started, set of disclosures. For full disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. I'm sure it's a very exciting website. If you have any questions, please reach out to your Morgan Stanley representative. And with that, Dave, you've got all the disclosure.

That's right. Thanks, Kristine. Good morning, everyone. Today, we're going to make some forward-looking statements, and those statements involve risks and uncertainties. Information about these risks and uncertainties can be found in our SEC filings. We may also discuss certain non-GAAP financial measures, and you can find a reconciliation of those measures to GAAP measures within our most recent earnings release. And with that, I'll turn it over to Kathy.

Great. Well, good morning. I have no more disclosures. So I'll go ahead and to provide some brief opening comments. Kristine, thanks for having us. It is so great to be back here and in person with you all. This year has been certainly a dynamic one. In first order, we've seen tremendous change in the geopolitical environment in which we're operating. The Russian invasion of Ukraine has really changed the European national security landscape, and I'll talk a bit more today about how that changes our view of the global market space for national security and defense products. The U.S. has also seen strong demand signals for national security. We've seen bipartisan support to the President's budget, which projected a 4% to 5% increase over last year. And Congress in conference, it looks like, is going to add to that to be more in the 8% to 10% increase year-over-year in defense spending in the U.S. And certainly, there is still a focus on the Asia Pacific region and the potential emerging conflict in that area. So overall, the demand side of the business has been incredibly strong. Northrop Grumman has seen increase in our backlog and has a very strong book-to-bill this year as we have for the last several years. Our focus has been on execution. Clearly, we have experienced some supply chain challenges mostly driven by labor, which impacts not only our company but our suppliers as well. We talked to this -- about this on our second quarter call. And what I will share is that over the last couple of months, we're seeing that trend continue to move in the right direction, meaning, our net headcount growth has continued to grow in the last couple of months. And so while we still see workforce-related challenges ahead, they are starting to subside. I also wanted to touch briefly on some of the amazing accomplishments that our team has had this year. We are delivering on 2 of the nation's most important programs related to deterrents, the B-21 or Raider program, and the Ground Based Strategic Deterrent program, Sentinel. Those continue to progress well. And we are really pleased with the work that we're doing with NASA, the James Webb Space Telescope launched late last year, but it was early this summer that we started to produce on firing images off of that telescope. And that is helping us to drive a talent agenda across our company to add to our current workforce and retain the workforce that we have. So all of this goes to supporting the strategy for growth and strong execution. We also have talked about our expectations for the year, and let me just reiterate that our guidance calls for about 2% organic growth this year, and we are looking to be on track with that. We also are having strong operating margin performance at the segment level, 11.8% is what we have this year. And we also are generating strong cash flows, and have talked about a double-digit CAGR in free cash flow growth through 2024 and still see a pathway to those longer-term outlooks as well. So I will close there with my opening comments and happy to address any questions that you have, Kristine.

Great. Thank you, Kathy. And touching on what you mentioned with Russia and Ukraine and also we're seeing activity in Asia Pacific, how have these events changed the geopolitical landscape? How big of a deal are these events today, and how does that change your strategy and priorities?

It certainly has driven the most significant change in Europe. We've seen addition of 2 more NATO countries. And if you go back to 2014 when the NATO countries made the commitment for 2% of GDP to be spent on national defense, only 30% of the countries had actually met that target. And they have until 2025, we have seen this year, obviously, a number of those nations who had not yet met the commitment, commit to do so. And so we do see an increase in European defense spending and the most marked change in that region. The U.S. had already, as I said, the President has supported a 4% to 5% increase year-over-year. We're expecting that to be closer to 8% to 10% when Congress is done and we have appropriations. That is strong year-over-year growth, and we're seeing good bipartisan support for the national security agenda. And then in Asia, we had already started several years ago to see an increase our Asian allies, defense budgets, And those also our commitments that we see, if not maintaining strengthening as the reaction to what's happened in Ukraine.

And Kathy, for those plus-ups that you were seeing from Congress, how are Northrop programs faring?

Our programs are faring quite well. I mentioned Raider and Sentinel, which are 2 programs that are seeing significant growth over the 5-year development plan from the Department of Defense. But we also see space with double-digit growth in the budget. We have other new programs like Next-Gen Interceptor that are well supported and have significant growth in the next couple of years through 2025. And so across our portfolio, we see a strong support, including an aero program where -- through the market process, we're seeing additions in aircraft programs and support for Trident to get back into production after a year pause. So all of these are really positive indicators for us.

Great. And we saw the plus-ups for the '22 budget, but that's after a lengthy CR. What do you think the likelihood is that we'll get another CR this year?

I do expect that we'll be operating under a continuing resolution. I'm hopeful that the Congress can have appropriations by year-end, but we have gotten used to the feel on our normal operating procedure, and so the industry and our company, in particular, good at managing through these risks. It may have some small impact to awards timing in particular, things that we had hoped to get on contract this year, but we still expect our book-to-bill to be around to one this year, which is what we had outlined as our expectation on our Q2 call.

And you mentioned in Europe, you're seeing for our NATO Partners 2025, the time frame for when they have to increase spending. But when you look at the threat environment, I mean, the threat is today, there's urgency. Can you quantify what -- or do you think that it could come earlier than 2025 for our partner spending? And how much of an opportunity is that for you?

Well, there certainly is going to be some near-term lift in the funding packages that the U.S. have for Ukraine. And for us, that's a fairly limited exposure on weapons in particular. And so that's why we've said it doesn't move the needle in the next 18 to 24 months, and we see the greatest opportunity being in '24, '25 and beyond. And that's not just thinking about what Ukraine needs to both, deal with conflict today and then rebuild into the future, but it also is thinking about broadly what we expect to happen in Europe and what the European allies will buy. And so as we look at what that looks like for our portfolio, we have a good bit of our portfolio that is not exportable, and so that has led to us having a lower percentage of sales internationally. We're not going to take the eye off the ball domestically. But at the same time, we now see the U.S. working to align with our European allies in ways that may make things in our portfolio that were once not exportable, exportable to those European allies. Particularly as we think about our Aeronautics business with the E-2D in particular, which is already going to France, we think there is more opportunity there. Our Unmanned portfolio where NATO has purchased Global Hawk, but the Trident and Global Hawk has capabilities that will be highly relevant to the European allies' agenda. So we do believe that those opportunities take at least a couple of years to mature and get signed, but there are things that we're pursuing.

And when you look at your international customers, you're, as you mentioned, lower than your peers because they're not exportable. So at around 15%, and some of your peers are 20% to 30%. When you take in consideration the opportunity in the next few years, could you get to that 20% to 30%? Or is the nature of the portfolio as such that you always just be below peers?

The good news for us is the capabilities that are not exportable like the B-21 or Sentinel are ones that are growing as well, and at a pretty nice rate over the next couple of years. So we -- to outpace the domestic growth, we'd have to grow international at well above double digits to be able to change that ratio. That is not an objective I've set for the team. I want to make sure that we're maximizing both the domestic opportunity and internationally. It's different things that are resonating with the U.S. than what we would sell to allies. The beauty of our portfolio is we have the breadth to support both, and that's exactly what's on our agenda.

Great. And following up that you mentioned on Unmanned, I mean, you have some Unmanned portfolio that's sunsetting, they're fairly mature programs. But then you also have the opportunity for the international export market. How should we think about the evolution of the Unmanned portfolio? And then we're seeing also demand signals from the Air Force for an uncrewed combat fighter. So how do we balance the sunsetting portion, the export opportunity and these new emerging Unmanned priorities?

For us, it's a product line strategy that we execute across many of our elements of the portfolio. It is taking capability that the U.S. had viewed as it's most modern capability as it then is going to be replaced with the next generation of capability. Like what will happen with unmanned systems, they are more open. The U.S. who is exporting that technology around the globe, we see this time and time again. And so these aircraft are still incredibly capable. And when I talk about these, I'm talking about high altitude, low endurance platforms like Global Hawk, like Triton. And they will, I believe, continue to have an international market space and demand. Then at the same time, we are working to develop those sixth-generation capabilities that the U.S. Air Force and U.S. Navy are looking for to be part of their total air combat solution. And our skills in autonomy, stealth, composite structures, all lends credibility to our ability to compete for those sixth-generation aircraft as well, both manned and unmanned.

And how should we think about the next-generation air dominance program? Because for the capabilities that you highlighted, that sounds like exactly what that program is expected to do.

Well, we think as we look at sixth-generation aircraft, we are developing the first sixth-generation aircraft and B-21 that has many of the characteristics that I just outlined. And so our experience both working system, whether it's manned tactical air or unmanned ISR, the capabilities that we've developed in those sixth-gen aircrafts are highly relevant to sixth-generation aircraft requirements. And we're looking to position that expertise both in prime and subworld, as we have done in our Aeronautics business previously.

Great. Thanks, Kathy. And now switching gears to Space, Space is now your fastest-growing segment, and your backlog even is about 3x segment sales today in Space. So you have GBSC as an anchor program, but also beyond that, you have a broader space portfolio. So first, can you talk about other programs outside of GBSC that's driving growth in the Space segment? And then also, we've seen the DoD investment pace at a double-digit for the past few years. How long can these growth trends last?

Well, I'll start with the last part of your question first. I see the trend in investing in space continuing because we are relying more on space for the missions that enable U.S. military operations, whether that be surveillance, communications, missile warning and tracking than ever before. And we need to continue to recapitalize the asset in Space to compete in this threat environment. So there -- I expect will be continued accelerated investment in the Space domain for the foreseeable future. And what that means is we see our portfolio well aligned because we have capability in each of those mission areas that I just outlined. Some of our growth is coming from those. You mentioned Sentinel, which is about half of the growth year-over-year that we've experienced. But Next-Gen Interceptor, part of the missile defense portfolio, is also contributing to that growth. We've recently been awarded the Glide Phase Interceptor program, and that will have growth in the next several years before moving into production. We were also just awarded the ground-based element of the mid-course defense, so the missile defense protecting in the U.S. And that was a $3.3 billion IDIQ award that we received last -- last month. So all of that is contributing to growth in our Space portfolio as well as national security space, which is about 30% of our portfolio, which is restricted. So we can't talk broadly about what it is and what it includes. But it is part of that recapitalization that I mentioned in providing knowledge, intelligence and warning across the broad spectrum of sensors.

And Kathy, for the space evolution and the space set that the DoD's undertaking with the recapitalization, what inning are we in that recap? Because you mentioned it could be persisting for longer, but are we still in the first inning? Are we in the fifth inning of this kind of recap? Or is this truly a secular growth that we could see through the end of the decade?

I would say we will see this through the end of the decade. And the growth rate will flow, of course, because many of these programs are getting started, and so we're seeing that early ramp, which is going to be steeper than what we'll see through the end of the decade. But I would say in terms of timeline, we're only in the second or third innings. Many of these programs are just getting started, and they have 10, 15 or, in the case of Sentinel, 30 to 50-year life spans. And so we will see them continue to develop and move from where they are today, which is in the research and development phase, into production and then sustainment ultimately.

Great. And diving deeper into Space. You mentioned all these programs with the NGI, you talked about GBSD, the ground mid-course defense, I mean, these are fairly large program wins. What differentiates your portfolio versus peers? And how are you able to win all these programs and really differentiate your Space portfolio?

In many of these areas, we were previously a supplier, and we are taking the capability of our entire company and demonstrating to the U.S. government that we can now lead through the prime systems integrator. And we've had mission knowledge and missile defense at the company for many decades. It's about bringing those piece parts together across our company, from our Mission Systems portfolio, our Structures portfolio out of Aeronautics and our Space business now together around this mission focus, and that's been a core part of our strategy. For the last several years, really, the way we have turned our company toward profitable growth in a more significant way is aligning our team around these mission campaigns. We know what the threat requires our government to have in terms of capability. We have a technology agenda, our very first strategic objective is technology leadership. And so we provide solutions to the U.S. government that are technologically differentiating against our potential adversaries. And then we are able position ourselves as a leader, not just a piece part supplier. And that's what we've done in missile defense as well as several other campaigns like national security space, as we think about sixth-gen aircraft, and advanced mission systems as well.

Great. And now switching to the capital deployment and maybe, Dave, this is a question for you. Northrop had bought back about half of its shares outstanding in the past 15 years. I mean, it's a phenomenal number. With a strong run up in the stock year-to-date, are you thinking differently about share repurchase? And then also taking that into consideration with the M&A environment where it seems like it's a more restrictive environment, how do you think about priorities for capital deployment? And how do we think about long-term return of cash to shareholders?

Sure. It's a good question. Certainly, a topic we think a lot about. First and foremost, our top priority for cash deployment remains investing in our business to maintain the differentiated positions and the technology leadership that Kathy has described in some of the key domains of the company. And so CapEx will remain a top priority for us to make sure we continue to fund the business and fund its outstanding backlog growth, and do everything we can to continue that growth going forward. Beyond that, in terms of uses of our free cash flow, we're in a good position these days in terms of feeling that our portfolio is well aligned with our customers' priorities. There are not significant strategic gaps that we're -- or desiring to fill these days. On the balance sheet side, we feel good about having achieved our target credit rating. We have our funded status of our pensions. It's stronger than it's been in many years. And so shareholder returns are at the top of our priority list for uses of free cash flow, and we will look to maintain a competitive dividend. We increased our dividend 10% this past spring, and that represents a nearly doubling of the dividend in the last 5 years. So we will look to continue to emphasize growth in the dividend to maintain a healthy competitive dividend position. And then you have share repurchase. And to your point, that's been a key component of our cash deployment strategy for a number of years. It will remain one, and that will continue to evolve over time. But at this point, that's how we're looking at the priority set.

And Dave, in that 15-year period when you guys prioritize more buybacks, we also saw leverage tick up. Is that something that you're looking into in the next few years?

So over the last few years, our leverage has ticked up substantially with the Orbital ATK transaction, and then we reduced that leverage to the point that we achieved our target credit rating. We're at a point now where we don't anticipate significant changes in our leverage level going forward. We feel like we've reached a good equilibrium for this point in time, and don't anticipate significant relevering or delevering in the near term. Certainly, it's something we'll continue to keep an eye on as credit market conditions evolve and uses of cash evolve as well.

Great. And maybe, Kathy, going back to your strategy. Earlier this year, you unveiled your -- or to us, the public markets anyway, your priorities, right? And that's maintaining technology leadership, which you mentioned. Sustainably growing the business, driving cost efficiencies and deploying capital in value-creating ways. When you look at how quickly geopolitical environment has changed, how has that either supported or affirmed or even changed these priorities? Is there one that stands out to you now that's even more important as we prepare for what's yet to come, and support what the Department of Defense wants to accomplish?

What has happened this year has really reaffirmed our strategy in many ways. And one that I'll point to, in particular, is our customers are very concerned about the speed at which they need the capabilities that we and others in the industry are working on to be matured and delivered. And so when you think about our strategy, technology leadership is helping the U.S. and our allies to have capabilities that will compete and that advance at the same rate, if not greater, than our adversaries. So technology leadership is fundamental not only to our success but our customer's success. And that will help our business grow. Growing profitably for us about risk reduction by and large. So the way we deliver profitably is the cost control, as you noted, but also managing the risk associated with these very complex development efforts. And there are a couple of ways that we're doing that. One is our digital transformation within the business. And you have heard the Air Force talk about how that is already yielding demonstrable results on the B-21. Being able to keep that program within its cost and schedule targets has largely been a result of us using more advanced digital models to help burn down risk on the program and alleviate the strains that are often found late in either development or even into production. That we've been able to identify those early, and work to address them so that the aircraft is coming together much more seamlessly. Those types of capabilities we are rolling directly into Sentinel. And we expect by 2025 to have a digital ecosystem inside of our company that all of our programs are operating in get the same benefit. We also, at the same time, are digitizing the back end of our business. So think about the back-office functions, and this leads to the third objective around cost efficiency. We are reducing facility footprint. We are increasing leverage across our supply chain for spend. And we are scaling our operations while minimizing the additional overhead and fixed costs necessary to do so. So these are all helping to address, again, the profitable growth of the business that is tied to that third element of our strategy. And at the end of the day, that's all about having more capital to deploy back into the business to support the first 3 objectives. So in my view, the strategy is executing extremely well, and it's holding up against even the changes that we're seeing. And [ speed ] being core, means that our business has to be agile. All of these are also helping our business to be agile because we're laser-focused on those 4 objectives.

Great. Thank you for the color. And switching gears to ESG. I mean, defense and ESG, is it really oil and water, or can we see a combination? I mean, so far, what we've seen from you is some thought leadership on trying to be compatible with some ESG framework. We see you exit specific contracts. You've named the new Chief Sustainability Officer last year. So how are you thinking about running a defense business in the context of ESG? And how has your conversations or your view on ESG changed with Russia's invasion of Ukraine?

Well, first, it hasn't changed my view at all about the need for a strong deterrence and national security agenda that we support as an industry. I think it has changed the view of others. It's been a wake-up call. But as much as we all would like live in a world that just naturally exists in a peaceful state, that isn't the world we live in. And so it is incumbent upon the governments with the resources to do so, to provide a deterrent framework and to keep world order and global peace. And I have often said, I came into this industry after 9/11 to really work on something that I thought made a difference for the world that my children would grow up in, and I still very much believe that that's what we're doing. So I don't think that defense and ESG are oil and water, I think they are very symbiotic. They go hand in hand, and that it is the responsibility of our industry to contribute to a more peaceful and sustainable world for our children. So with that said -- then what do we do about it? We have to be responsible in the way we do our business, and that's environmentally responsible. So we've set some very aggressive goals for ourselves in looking at our impact on the climate and getting to net zero by 2035, and we've got a do so with milestones along the way. We also have been very committed to diversity, equity and inclusion. Partly because it's the right thing to do, but partly because it's the way we attract and retain the talent that fuels the business value that we have. And then finally, from a governance perspective, we do look at our portfolio and make sure that if elements of our portfolio aren't well in lined with our intention or our investors' evaluation of our intentions, we address those issues. So we're getting out of depleted uranium, and we've made some other decisions in our portfolio that I think make us more investable. But at the end of the day, we are a company that supports deterrence and global security, and we're proud of that.

Great. Thank you, Kathy. And so with the time that we have left, we probably have time for 1 or 2 questions from the audience. So please raise your hand, and we'll get a mic to you.

I don't know if this is an ESG question or not, but there's a lot of talk before Ukraine about hypersonics, and in the speed of which that really controls the decision or shortens the decision time frame for command and control of... And so, how are you thinking about kind of the FX behind a soldier monitoring a system that's going to do lethal harm versus a soldier making the decision, or basically monitoring an automated system that's making the decision?

We are working with artificial intelligence technologies, and we take very serious the responsibility. And to wrap around that ethical AI, how do we ensure that there is positive human control over the artificial intelligence that's embedded in solutions, particularly to the extent that they might be weapons control systems? And I will tell you, we have not yet moved to where AI is being used in the weapon control loop. It's largely being used in autonomy as we think about teaming of systems and how various systems would cooperate with one another. It's being used to process sensor data, to take large amounts of data and make intelligence from it. But our company has not yet moved into weapons control using AI, and we want to make sure that we have a very strong sense of how we would govern the technology in a situation like that. And I will say the Department of Defense in the U.S. has been equally cautious. They are investing in these technologies to make sure that before we would use them, they are risk reduced in that regard.

Craig?

Craig [indiscernible]. With regard to pension risk transfer, is that something you have ever considered or looking at? I know peers have done that recently.

Sure. We evaluate all of our options regarding our pension plan. As I mentioned earlier, we've improved our funded status over the last several years to the point where we're approaching 100% funding level. But certainly, it's an option we continue to look at in terms of risk transfer over time. And different companies are in different situations in terms of funding status and cost reimbursement by the government. We're at a point now where we feel good about the level of funding that we're at and the ongoing reimbursement kind of projections based on that, the affordability for our government customers that results from that, the risk profile. But it's certainly a set of factors we will look at every year going forward and assess whether the time is ever right for us to consider something similar.

Well, great. This is all the time that we have. So thank you, Kathy. Thank you, Dave. And this concludes the session.

Thanks, Kristine. Thank you.