Northrop Grumman Corporation (NOC) Earnings Call Transcript & Summary

Okay. Great. So we'll get started. Hi, good morning. Welcome. I'm Morgan Stanley's Aerospace & Defense analyst, Kristine Liwag. Very excited to host our next session with Northrop Grumman. Very excited to be on stage with Kathy Warden, Chairman or Chairwoman of the Board, CEO and President of Northrop Grumman. Kathy, welcome, and thank you for being here.

Thanks, Kristine. It's great to be back with you again this year. I am going to make a few opening statements. Before I do, I just want to remind you that I may make some forward-looking statements today, and those statements include risks and uncertainties. You can find more detail on those risks in our SEC filings on our website. Just to kick things off, I want to share that it is a really exciting time to be in the defense industry. It is a dynamic environment, one that has stronger U.S. and global demand than we've seen in many decades as both the U.S. and our allies are recapitalizing and building out capabilities for both their sovereign defense as well as to project peace through strength. And as we look at the portfolio that Northrop Grumman brings to that challenge, we have a very diverse portfolio. We have been investing to build capacity in that portfolio, over $13 billion of investment in R&D and CapEx over the last several years, which is positioning us now to be ready to deliver for our customers with the speed and the quality that they need. As we project that into the end of the year, we're focused on performing on our commitments, but also positioning for a number of new exciting opportunities. And we'll talk some more about those today, areas like Golden Dome, the continued build-out of weapon systems, the nuclear triad where we are leading on 2 legs. And all of these areas have been very well supported in the Reconciliation Bill, which has added significant funding for U.S. priorities. So I'm excited to be here today and to answer your questions about both the geopolitical environment and backdrop that we operate in as well as the Northrop Grumman portfolio.

Thank you, Kathy. And you know what you said about peace through strength, I think that's a very remarkable statement. And I'm glad that that's part of our strategy as a country. It's important to focus back on peace.

It is.

So I guess, going into the geopolitical environment and also the dynamism we have today, we're now 9 months into this new administration and there seems to have been significant changes occurring, how do you think about the changes occurring in this environment, the priorities of the administration? And how does this leave Northrop Grumman? Do you see the environment more positive or negative for the company?

We see a tremendous amount of consistency over the last decade in the priorities of the United States. Those consistencies include a focus on the buildup of capability by countries like China, the aggression of Russia, and being able again to deter potential adversaries from taking action that's not in the best interest of the U.S. and our allies. And really, as you noted, to have peace and stability around the globe. And so those priorities remain strong in this administration and a cornerstone of the national defense strategy that this administration is outlining. But there are also some new areas of focus: the defending of the homeland and helping our allies to do the same. So Golden Dome, of course, is a manifestation of that in the U.S. But also working with our allies, particularly in Europe, to be able to build up their sovereign defense to protect their homelands as well. And so those areas are consistent, but higher priority as we sit here today than we would have envisioned 12 months or so ago, and they, therefore, represent new opportunities for companies like Northrop Grumman. But at the same time, priorities around the triad recapitalization that have been and continue to be the cornerstone of U.S. spending are also central to our portfolio. So we are making sure that our company is able to move at the speed of relevance and focus on our operations to do so, that we have built out the capacity needed to be responsive to this increased demand environment, and that we are working with our allies, so a real focus on growing our international business to help our allies get access to some of these capabilities as well.

You called out Golden Dome. Can you give us more color regarding the opportunity set for Northrop on this program? How do you see this evolving?

We see Golden Dome as a multilayer architecture, and the different aspects of the capability needed will happen in different time frames. So let me unpack that for a moment. There are some capabilities like regional defense that include integrated air and missile defense, counter-UAS systems and those are already available today. We are producing those types of capabilities often to be forward-deployed at military operating bases to defend our troops who are operating in those regions. And so the U.S. government has the optionality of just buying more of those existing programs to fulfill the needs in those areas of homeland defense. But then there are also other areas like space-based interceptors where that capability does not exist today. Elements of it do, that will lead to mature technical offerings over time, but those are going to be more development programs, and so those will follow a more traditional acquisition path. So I think all of this will happen in parallel. General Guetlein has been confirmed by the Senate to lead this effort in the U.S. He is working on an architecture which will provide more clarity on what will be acquired as well as the acquisition strategy of when and the funding applied to each of these streams of efforts. But it's important to remember, it's not one big acquisition. This is many programs, some existing, some new, that will come together to fulfill needs of the homeland architecture.

That's very helpful color. Regarding the budget environment in the U.S., we're seeing the fiscal year '26 budget monetization could be up over 20%. We're also seeing significant budget increases from our European allies. How do you think about that environment? And what's the medium or longer-term growth outlook for Northrop? Do you see an opportunity to break out beyond your historical mid-single-digit growth outlook?

That opportunity certainly exists. And it was what I mentioned in my opening comments, that this really is an exciting time to be in the industry to make an impact that for multiple decades we've been working toward, but now the resources exist both within the U.S. and our allies that meaningfully change the trajectory of these modernization programs that are underway. And so what we look to is some certainty that is likely to come as we get through this first budget cycle under the new administration. The Reconciliation Bill certainly provided significant resource and points to areas of our portfolio that we know are high priority, like the B-21, and the potential for ramping that program more quickly, the additional resources that were applied for the Sentinel program, about $2.5 billion, and other things in our portfolio that are benefactors of Reconciliation funding create that opportunity for ramp in the U.S. But then there are also new programs. We're waiting for award. And as those are known, those could also create some upside for us as we look out over the next several years. And then at the same time, you mentioned international. Our book-to-bill for international last year was 1.4, continues to be growing this year. Our business grew 18% international in the first half of the year. And we've said we expect that double-digit growth to continue. So we really are seeing tailwinds in both areas and continue to ensure that we are investing in the capacity that allows us to ramp as quickly as our customers need us to.

Kathy, on the fiscal year '26 proposal, we saw a pretty significant support for the B-21 and the Sentinel. And you've called out the monetization of the nuclear triad continues to be a priority for the U.S. government. Can you level-set us regarding these programs? How did their strategic value really change? Because there's a significant step-up in dollars. And then also, how do we think about the ramp of these programs in the coming years?

So B-21, as I talked about extensively on our second quarter call, we're in discussions with the Air Force to change the rate, increase the rate, at which we would build the aircraft. And that would create more resources being applied, first, to build the capacity to increase the ramp, and then over time, the annual profile of revenue for that program. And we expect those decisions to be made this year. So more to follow on that. Sentinel is also receiving funds in Reconciliation, mainly over these next couple of years, to look at ways to accelerate the fielding of the capability. And that's everything from design trades that can allow us to move quickly through engineering phase of the program to risk reduction activities in the field, on the silos themselves. And all of that really just sets the stage for us to move more quickly as the program marches through this engineering and test phase of the program and into production in the early 2030s.

Great. And diving deeper into the -- sorry, in the B-21, you mentioned you've been in discussion with the Air Force to accelerate -- potentially accelerate the program. Can you help us understand the puts and takes and the financial implications for you should we see acceleration of the program without significant changes to the contract structure?

So part of the discussion is determining the program plan and what that rate would be and, therefore, what the resources required to facilitize to that rate would be. We do expect that that would result in investment that Northrop would need to make in capital. And we also expect that we would get the opportunity for increased returns, meaning incentives on the program to make that investment and hit certain milestones to achieve returns above the baseline program. And so that's what we're working with the Air Force right now. And as I talked about on our second quarter call and as outlined in our disclosures, we expect to have some decisions on that this year that then we would reflect into updates to our outlook going forward for the program.

And shifting to the Sentinel. The Air Force has been talking about restructuring the program to take out costs. But in the quarter, you took a nice positive EAC adjustment, $76 million in the program. Can you talk to us about -- can you talk to us about the financial implications of this? How do we think about the risks of the program, especially when there are cost takeouts that need to be done in the program that's not part of your capabilities but still part of the entire Sentinel piece?

Yes. Well, part of our role in this phase of the program is to help the government think through their options for meeting the requirements of the program, that is the design that we are working. And through the restructure, because the cost particularly of construction had grown, there was a desire to see what design trades could be made to bring that cost back in. That's what we are working through with the Air Force, and they are now working to make decisions about those requirements, trades and make design selection so that we can move that phase to finish the design and move on with the program. This particularly affected the piece of the program that is in the operational field, what we call launch facilities. The missile development was moving along at pace. And so now we're bringing all of those pieces together for the full system design, and we will be able to make those important trades together at the system level and move forward. So that's the real breakthrough that we had earlier in the year. It led us to have more certainty around what would happen during this restructure phase and beyond. And then that led to us reflecting that information in our estimate to complete in the second quarter and taking the opportunity and the profit pickup that came with that.

Great. Helpful context. And you highlighted already international sales was up 18% year-over-year. Can you talk more about the opportunity set? Which particular regions are you seeing the most demand? And also from your product portfolio, where are you seeing differentiation in your capabilities versus what's available in the market?

We are seeing our international growth come pretty holistically across the enterprise, with the exception of our space segment, which is still mostly U.S. We, in our Defense Systems, are seeing the most significant international growth, and it's largely in areas like integrated air and missile defense, as you would expect, as countries think about defending their homeland, having that situational awareness to be able to defend against short and medium range. Missile threat is paramount right now, and that's our IBCS product line. But we also are in the business of both priming and supplying solid rocket motors for tactical missiles, where we have seen a step increase in demand signal coming out of our allies, particularly in Europe, for replenishment of weapons they provided to Ukraine as well as just their own stockpiling. And then in addition, in our Mission Systems business, there is a recapitalization of sensors that is happening in all areas: radars, electronic warfare, self-protection systems for aircraft. And so our Mission Systems business is also seeing fairly significant backlog increase for international. And in Aeronautics, it's specific to a couple of product lines, E-2D, Triton, where we are seeing increased requests for those capabilities as well.

And Kathy, how do you think about your go-to-market strategy for international customers? We've seen other primes also partner with the domestic champions. Do you plan to go to market as Northrop or find additional partners? And where do you see the opportunity set?

We absolutely are partnering. We needed to do 2 things. The first was have more products to export, and that was within our control and we worked over the last 7 years to build up our product portfolio of things that could be exported. And we have accomplished that objective. Now we are in the process of defining partners, usually by product line and country, that are able to help us to integrate these capabilities into their sovereign offerings. IBCS is a terrific example of this. We always go to market with a partner because the product itself is about integrating the local sensors as well as their weapon systems into the IBCS architecture. And the companies best positioned to do that are the ones in that country who has either built or are operating those systems today. They bring that expertise to us, we're bringing the technology, and we're working hand-in-glove to deliver those. But for each country, it's a different partner because their local knowledge is so key.

So as we see international continue to pick up, at some point, what percent of the portfolio do you think will be international for Northrop? And then how are the financial profile of these international orders different from the domestic ones? Could we see potential margin expansion?

We do believe that our international growth will be a margin tailwind. The business is and, we expect, will continue to be accretive to our margins. And we have not set a goal for percentage of sales from international, but we have set a goal for international to continue to grow double digit and outpace our domestic business. So by definition, increasing our mix in international. The reason we're not setting a goal is U.S. demand is also very strong and our company is very well positioned to go after it. So we want to see that part of our portfolio expand simultaneously. So we're really driving for above-market growth in both domestic and international.

And shifting gears, you realigned the strike and surveillance aircraft solutions business from Defense Systems to Aeronautic Systems earlier this year. And last year, you also realigned the Strategic Deterrent Systems division from Space to Defense. Can you talk about the rationale here, your approach to portfolio management and the benefits you're seeing from these recent restructuring activities?

So we don't restructure for just the purpose of moving pieces of the portfolio around. It has to have a strategic reason to do so. And when we were managing the portfolio and decided to sell our services businesses a couple of years ago, some of the sustainment to support work transferred outside of the company. And when we looked at what we retained, it was largely support to systems that Northrop Grumman builds and deploys. And so that sustainment expertise that was sitting in our Defense Systems business has synergy with our Aeronautics business. It's actually fielding these systems and modernizing them over time. So for instance, B-2 sustainment is highly relevant to what we learn and then deploy into the B-21 upgrade as we go to deploy those and sustain them over time. So we wanted to bring those teams together. And that's what we did with the movement of that portfolio from our Defense Systems business into our Aeronautics. So now the whole life cycle of our air platforms resides in our Aeronautics business. Likewise, when we were making that change, we made the decision to take our Sentinel program, which had been a direct report to me, and combine it with the rest of our Defense Systems business, because it's strategic missiles and the rest of that business is largely tactical missiles and integrated air and missile defense. So a very common set of technologies, albeit different sizes and applications, but we could leverage the engineering workforce across that entire portfolio by bringing it together. So that's the reason behind those 2 particular moves. But more importantly, strategically, we only make those moves when we see that there is more benefit than the risk of disrupting and moving parts of the company around.

You've also divested the training business in your Defense Systems. Should we expect more pruning to come with the portfolio?

We constantly look at the portfolio to make sure we're the best owner of each part of it, that we have the portfolio we need to fulfill our customers' needs, not just today, but well into the future as we see the market shifting. The market has been fairly consistent over these recent years, as I talked about earlier in this discussion. So we don't see major gaps in our portfolio. We like what we have. We've been investing in it. So you might see us continue to do some small pruning like we did with the training services business, but we don't see anything significant on the horizon that we would likely divest in, nor do we see M&A as a main driver for us over these next few years? Because we have such an opportunity-rich environment by spending that capital, investing in the capacity we need to seize the growth that I've already talked about.

Great. Regarding the F-35 -- I mean, we just had Lockheed at the previous panel. You're a significant subcontractor to the program, I've had a chance to visit Palmdale a few times; it's a pretty phenomenal facility. How are you thinking about the uncertainty regarding the buy order from the U.S. customer? And also for the international partners, there seems to be some hesitation, reconsidering of some orders, but then there are also new customers and new volumes at play. What's your outlook for the program? And how do you think about the revenue contribution of the F-35 to your portfolio?

We expect it to be relatively stable. A number of moving parts under the surface, obviously. We have the work that we do in production. It's largely driven by our aeronautic sector and the building of the center fuselage. We are standing up a second source, Rheinmetall, to complement our production facility to replace PAI from Turkey who was providing that excess capacity. And so we feel like we have what Lockheed needs to be able to produce at the rates they're projecting, and we don't see much change there. I will note about 40% to 45% of what we are building today, because we built a bit ahead of the units being delivered, is for international customers. And the international demand remains strong. When you look at the rest of the portfolio, we have Mission Systems also working production. Modernization is driving sales right now. And sustainment is increasingly a key part of the revenue composition for us on F-35. So we expect all of those dynamics to continue into the foreseeable future and, net-net, be about even with where we are today.

Shifting gears to the emerging defense tech players. I mean that seems to be the term de jure here, emerging tech, and with a big, fat multiple. They're getting a lot of investor traction and investor mind share for sure. And some have actually won some significant Department of Defense -- or Department of War contracts. How are you thinking about this momentum both from a potential competitive standpoint and also partnership standpoint? How do you think they live in the ecosystem? And where do you see the value in your portfolio? Would you consider buying one of them, partnering one of them? And are there parts of the Northrop portfolio moat that you're not worried about that they could potentially take market share from?

A lot to unpack there. Let me start with we welcome the competition and we welcome partnering. That is how the ecosystem works, and we embrace new companies coming into that ecosystem. Today we are partnering with most of what you would define as new entrants, in one way or another. We don't do partnerships for the sake of partnerships. We do them when there is a capability that that partner has, when added with ours is complementary and can lead us to have the right offering for the government. And so you will see us talk about those partnerships in more specific ways than overarching ways, but nonetheless, they are happening with those companies. We are also, though, competing. And I'm pleased when we go into a competition and are able to, head to head, demonstrate, because that's when a company shines, like ours, is innovating and bringing new technology, and performance can be evaluated. So we're seeing that happen as well. And I feel good about how our team is faring in those head-to-head competitions, both with our traditional competitors and the new entrants. And our company is very familiar with new acquisition approaches. We are one of the top companies in receiving other transactional authority contract awards, far more than any of the new entrants. So we know how to compete even outside of the traditional acquisition system, and we've demonstrated that over the last few years. So really, I think it's healthy. I embrace competition, and I take new entrants as seriously as I take more traditional companies. We compete vigorously, but we also partner when it makes sense. And I think in this time of high demand, there's a place for all of us.

Yes. And Beacon. You unveiled Beacon. It's a flying mission test bed that can help companies hone autonomous software from multiple companies. Can you talk more about this capability? First, what is it? How meaningful is this capability set? And is this an emerging partnership model that you can lean into?

Yes. So Beacon, for those of you who hadn't heard about what we announced, it is a test bed for autonomous systems. Our company was one of the first to have a fully autonomous vehicle. And we have over 500,000 flying hours, which is more than any other company. And we wanted to bring that expertise to a test bed that could help other companies come in and demonstrate their innovations, learn by being able to apply those in a high-fidelity model based on all of that flight experience, us see who we might partner with as we look at future opportunities in autonomous systems, and have a resource that not only benefits our company but benefits the ecosystem as a whole. If you say, "Well, what's in it for you?" Well, what's in it for us is being able to learn, partner and embrace the best of the best to bring forward solutions for the U.S. government. That's what we are in business to do. And when we do that, we find that our win rate goes up and we have the best product. So we want to create environments where that kind of partnering can happen, back to your previous question. And we think that it's going to let the best companies demonstrate what they're capable of doing in a realistic flight simulation environment.

This question I always tried asking because I can't sleep at night after I hear your answer. But what keeps you up at night? What are you worried about in this environment? Look, portfolio aside, it seems like you have the -- you're seeing the dollars come through for the programs that you've invested in. So that's materializing, the portfolio is in great shape. So what are you most worried about? What keeps you up at night?

Yes. The threat environment. That hasn't been my answer when you've asked me that in recent years. But I will say the escalation that I'm sensing both domestically, regionally and globally, it continues to escalate. It's what's driving the demand that I just spoke about. And in many ways, that supports our industry, but in other ways, it's a signal of the lack of global stability that we are operating within. And so that does keep me up at night. It's why I came in to this industry, 24 years ago today, the anniversary of 9/11, some of you know, I came into this industry after 9/11. I thought I'd stay for a couple of years, do my part for national security. It's why I stayed in this industry this entire time. And I think as Americans, we really have to take a moment to really reflect on what's happening in the world and get back to peace through strength. Peace through strength.

Well, thank you very much, Kathy. Thank you for being here with us today and sharing your thoughts. This concludes our presentation with Northrop Grumman.

Thank you.