Northrop Grumman Corporation (NOC) Earnings Call Transcript & Summary

Hello. Good morning, everyone. I'm Kristine Liwag, Morgan Stanley's Head of Aerospace and Defense Equity Research. I'm very, very excited to host our next panel with Kathy Warden, Chairman and CEO of Northrop Grumman. Kathy, welcome.

Thank you, Kristine. It's great to be back with you.

So as you guys know, for important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative. So with that, Kathy, I'm very excited for you to come back here at Laguna. So maybe I'll pass it on to you for some opening remarks.

Yes. Well, let me start, too, with a couple of disclosures. First, I am likely to make forward-looking statements throughout the conversation, and those have inherent uncertainties and risks, so please refer to our SEC filings, which you can find on the Northrop Grumman website for a full list and discussion of those risks. Just want to start by saying that we are in a very robust demand environment. When Kristine and I were together here a year ago, I believe I characterized it as the most robust I've seen in the 20-plus years that I've been in the industry. And as I sit here today, that environment is translating into backlog and awards for our company not just in the United States, but with our allies around the globe. We have a record backlog once again. We continue to build on that backlog with franchise programs like the B-21 and Sentinel as they scale through development and into production, but we're also adding market share in munitions as they accelerate, and we grow our footprint on those weapons. We are growing in national security space, which you know is becoming an increasing imperative for the U.S. and allies to not only have situational awareness in space, but to be able to conduct operations there, and that business is also growing double digits. So just a number of catalysts within our company and broad-based growth across all 4 of our operating segments. We also, as we are shifting from more development work to more production work, seeing tailwinds to margin that come as we mature the products and are able to have the tailwinds of mix that we've talked about before. And international, as it grows, is also providing tailwinds to our margin profile. So as we execute the strategy that we have been executing for the last several years, we really are at a point where these catalysts in our business are starting to translate into more value creation through the decade. And I would say we are as optimistic as ever about the robust bipartisan support in the U.S. for national security spending, the fact that our programs are supported in the base budget that the President submitted to the Congress and that we are also seeing this robust international environment. So with that backdrop, I know you want to explore several areas that I've just touched on in our portfolio. So I'll turn it back to you, Kristine.

Thank you, Kathy. So maybe touching on the demand environment. You talked about the robust demand, but if we could pivot to the funding dynamics, right? The House and the Senate Armed Services Committee and the House of Appropriations Committee, they've each backed that $1.1 trillion budget for the fiscal year '27 base, and it's good to see that your programs are funded there. But that said, the reconciliation request, supplemental, and now we're in a continuing resolution. These are all areas of uncertainty for the funding levels. Can you talk about how much of Northrop's growth is driven by the base budget outlook versus the contingents and reconciliation? And how do we think about the risks to your business if the CR is extended for longer? And I think historically, it's around 90 to 100 days on average.

Yes. So our programs are largely supported in the base budget and fully funded there. They aren't split between base and reconciliation like some other areas. And so we see what is in reconciliation largely as upside to the outlook that we have been providing for the company's growth. And as we also look at the base budget and how well our programs are supported, it's an indication of that enduring and sustainable demand signal for those programs that they are included in base. Now we do believe that there is room for some of the reconciliation and supplemental priorities to be funded in addition to the base budget. But to your point, we think that's unlikely to happen in the near term. So again, having our programs in base will allow us to continue to fully execute those programs on their current profile. The continuing resolution, of course, both the House and the Senate have agreed to extend funding through continuing resolution in early December. It is unlikely, we believe, that a budget will be passed at that time. So likely that the CR will be further extended. But this is something that our industry has become accustomed to. It's not good for national security. We need timely appropriations. It does cost the government more when we have these extended periods of continuing resolution. But at the end of the day, as we look at our programs, we have the funding we need to continue to work and believe that's the case even into early next year.

That's really helpful, Kathy. So on B-21, you've said that the Air Force's analysis of a larger B-21 program extending beyond 100 aircraft, it should conclude by year-end. So first, where does that stand now? Do you have indications of what the Air Force may be leaning towards? And then also separately, when we think about margins, Aeronautics margins moved up to 10.3% in Q2, and you've got a full year mid- to high 9% guidance for the segment. How much of that improvement is B-21-specific versus the mature production programs? What are the puts and takes in the Aeronautics segment when we think about margins?

Well, let me start with the B-21. We, of course, earlier this year, came to an agreement with the Air Force to accelerate the rate at which we are building the aircraft, and we are in the process of facilitizing to do that. That then positions the government to consider increasing the overall program of record, meaning how many aircraft they will buy as part of the program. And I don't want to get ahead of them. They are conducting that analysis now. I do expect them to share their conclusions with the Congress later this year, and of course, with all of us. At the same time, to your point, we are progressing B-21 through development. We have also started low-rate initial production on the program, and I'm really pleased with the performance as is our customer, the U.S. Air Force, they continue to share very positive progress as the program is being tested and meeting its test points, which then positions us to move to producibility knowing that we have a design in this aircraft that delivers the capability that our Air Force needs. They also look at this as a multifunctional aircraft. So originally, as part of the Triad, it was an aircraft that was designed to meet part of the nuclear triad mission, but it can do so much more. And that really is the basis for the Air Force now looking at their whole force structure and seeing the B-21 as a platform that they can use for other missions. And so we feel that this program of record expansion is a reflection indeed of that long-term demand signal for the platform. The AS portfolio, our Aeronautics segment, is performing exceptionally well on our mature production programs as well. So when you asked about the margin profile in that business, while the B-21 is doing well and in alignment with our estimate complete for the program, it is really those other mature production programs that are generating the higher-than-anticipated margins in the segment this year.

Great. And do you anticipate that these programs will continue to be a tailwind in the second half?

We do. So we had increased our segment level margin guidance, as you know, and we just continue to see that team step up and deliver.

Great. Now moving to the multiyear and solid rocket motors, which is a topic du jour. So you've identified 10 multiyear agreements in total with roughly $10 billion of opportunity over the next 7 years. And you've also been qualified as the second source supplier for the solid rocket motors and the PAC-3. So as these definitize, how should we think about the opportunity set, how quickly can you move? What's the budget visibility and funding for these multiyears? And also, when can you provide more color regarding the 8 agreements beyond the PAC-3 and the THAAD?

So let me unpack the 10-part question around the 10-part munitions acceleration that we have. We have numerous opportunities in the munitions acceleration space. You noted PAC-3, and we are far along in discussions with Lockheed Martin as -- to being the solid rocket motor provider for a portion of their buy. And we first had to qualify. That is complete. Now we are in the process of ramping production and meeting increasingly higher targets for delivery. We are feeling very good about how that's progressing and simultaneously working our way through contract negotiations. That is a model of what we are doing on a number of weapon systems. In some cases, we are looking to qualify as just a solid rocket motor provider. In others, we produce seekers, cases, nozzles, fuses, so we are really a multiproduct line contributor to munitions of all types and sizes. And so we are taking this opportunity to work with partners we have not worked with before, show them the products we have and define what our path is to gaining share on those weapons. There are 10 agreements, about 8 weapons that we are in active discussions with various clients on.

And by the way, Kathy, I think from our Lockheed session earlier today, I mean, they're talking about 2x, 3x, 5x. I mean these are very high volume multipliers. So when you think about the CapEx requirements that you have to make, can you share your views on what kind of investments you have to do if these things materialize into definitive agreements?

Yes. Just to take you back a handful of years, you will recall that we acquired Orbital ATK in 2019. And as part of our getting into the weapons business in a more earnest way, we began to invest in that business. We were building out capacity because we saw the opportunity coming. We didn't see it at 3 or 4x. But we saw the opportunity to gain share on what's -- where Orbital ATK did not have a presence and that is Northrop Grumman, we had more to offer than just rocket motors. And so that strategy has been in place for a while. We started the investment before we got on contract and what it has allowed us to do is come at these opportunities with a running start. We have built 2 additional plants where we can build solid rocket motors. We have 2 others that are nearing completion for production capacity. And that is what now we can bring to the table when we talk to companies like Lockheed Martin about fulfilling this much higher demand signal that they've been given and it's opening their aperture to new suppliers like us. So it's really a win-win. And having made that investment is what got us to the table, now ramping through the facilities that we have is going to allow us to gain share over these next couple of years.

Very helpful color. So on Sentinel, Sentinel backlog grew to $7.6 billion in the last quarter. You've talked about targeting a milestone B by year-end. What's there left to do before you reach this milestone? And also, are there other milestones we should keep in mind before initial operating capability of Sentinel?

Yes. Largely, what has happened in the last 12 months is we've matured the design. The Air Force has made important decisions and selections around the operating model for this weapon system, and it has allowed us to move forward on all 3 segments of this weapon system. One, of course, is the missile itself, where just this week, we showed all of the missile stacked. So all the components of the missile are built, and we have integrated them for the first time. We are planning its first test next year in 2027, which is earlier than was anticipated. We are really working in close partnership with the Air Force to accelerate this program to the extent possible knowing how important that it is. The other 2 components constructing the missile silos and command and control for the weapon system are also progressing very well. And now it's really just about executing over these next few years to complete the development program, finish the testing and move into production in the 2030.

Great. Now Kathy, on Mission Systems, I'm going to be honest here. That's probably one of the hardest segments for analysts, and I'm sure the rest of The Street to model for Northrop Grumman. So can you share with us your vision, what is the strategic vision for Mission Systems? And then also, any color you could provide regarding revenue trajectory, margin trajectory, free cash flow profile of this segment would be really helpful.

It, I am sure, is one of the toughest portfolios to model because it, very much, is a product line business of microelectronics that go into all types of platforms from undersea to outer space. And we are often a supplier, not a prime. We develop things like radars, electronic warfare suite, communication suites, but then they go on to platforms in an integrated fashion. But the value that, that segment provides, it is our highest margin business. It has the highest return on invested capital because it's not one of our more capital-intensive businesses, but we do invest more in R&D in that business than any other. And we do that in conjunction, oftentimes, with partners. So other companies who are progressing the state of the art in microelectronics or working with partners to integrate those electronics onto their platforms. And that has been a great source of value creation, not just for our shareholders, but as you look inside our company, we are vertically integrated in segments where microelectronics can make our platforms even more capable and we have the ability to inside the company, have that teaming and engineering integration. So that is the value of the segment from a perspective of the company. For our customers, this really does give them the edge. Operating in the electronic spectrum is often times today the difference between survivability and range, things that are very important to our customers. So innovating in this segment is about giving the U.S. and the allies the capabilities they need to compete.

Great. Thank you. Switching gears to Marine. So Marine Systems, especially nuclear propulsion for submarines, came up this quarter as a key growth driver. How big of a piece of Mission Systems could that become as those programs continue to ramp? And how should we think about Northrop Grumman in the Marine space? It's not typically where we think you guys are?

So we do provide propulsion systems for nuclear-class submarines. And as you know, this is a growing area. The business for us today is over $1 billion, but we do see it as a key growth driver as those platforms scale over the next decade in production. And we are working on increasing our rate of production to keep pace with the shipbuilders. We see this business as, again, a provider of a capability that is game-changing for the submarine. And even though we are not the prime integrator, our technology is very tightly integrated into the sub, and we have been a good partner in this business for decades. It's not one that we talk a lot about, as you said, but it is one that's very important to our nation and that our company has invested in to ensure that we stay at the leading edge.