Northrop Grumman Corporation (NYSE:NOC) Morgan Stanley 10th Annual Laguna Conference Call September 14, 2022 11:00 AM ET
Company Participants
Kathy Warden – Chairman, President and Chief Executive Officer
Dave Keffer – Corporate Vice President and Chief Financial Officer
Conference Call Participants
Kristine Liwag – Morgan Stanley
Craig Sheppard – Apollo Global Management Inc.
Kristine Liwag
Hey, everyone. Thanks for joining our next session. I’m Kristine Liwag, Head of Aerospace & 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, standard disclosures. For important 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 [indiscernible] disclosures.
Dave Keffer
That’s right. Thanks, Kristine. Good morning, everyone. Today, we are 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 reconciliation of those measures to GAAP measures within our most recent earnings release.
And with that, I’ll turn it over to Kathy.
Kathy Warden
Great. Well, good morning. I have no more disclosures, so I’ll go ahead and just 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 have seen tremendous change in the geopolitical environment in which we are 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 have seen bipartisan support to the President’s budget, which projected a 4% to 5% increase over last year and [Congress in conference] 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 about this on our second quarter call. And what I will share is that over the last couple of months, we are 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 two 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 are doing with NASA. The James Webb Space Telescope launched late last year, but it was early this summer that we started to produce all inspiring images off of that telescope. And that is helping us to derive 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 the strong execution.
We also have talked about our expectations for the year and let me just reiterate that our guidance costs 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 projected this year. And we also are generating strong cash flows and have talked about a double-digit CAGR and 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.
Kristine Liwag
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 has that changed your strategy and priorities?
Kathy Warden
It certainly has driven the most significant change in Europe. We’ve seen addition of two 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 3% of the countries had actually met that target. And they have till 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 had 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, but that is strong year-over-year growth. And we are seeing good bipartisan support for the national security agenda. And then in Asia, we had already started several years ago to see an increase in 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.
Kristine Liwag
And Kathy, for those plus ups that you are seeing from Congress, how are Northrop programs faring?
Kathy Warden
Our programs are faring quite well. I mentioned Raider and Sentinel, which are two programs that are seeing significant growth over the five-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 ARROW program where through the market process, we are seeing additions in aircraft programs and support for Triton to get back into production after a two-year pause, so all of these are really positive indicators for us.
Kristine Liwag
Great. And we saw the plus ups for the 2022 budget, but that’s after a lengthy CR, what do you think the likelihood is that we’ll get another CR this year?
Kathy Warden
I do expect that we’ll be operating under a continuing resolution. I’m hopeful that the Congress can pass appropriations by year-end, but we have gotten used to the speed, our normal operating procedure and so the industry and our company in particular are 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 one this year, which is what we had outlined as our expectation on our Q2 call.
Kristine Liwag
Great. And you mentioned in Europe, you’re seeing for NATO partners, 2025, the timeframe for when they had to increase spending, but when you look at the threat environment, I mean, the threat is today – there is urgency. Can you quantify what – do you think that it could come earlier than 2025 for our partners spending and how much of an opportunity is that for you?
Kathy Warden
Well, there certainly is going to be some near-term lift in the funding packages that the U.S. has 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 2024, 2025 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 us having a lower percentage of sales internationally. We are 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 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 Triton and Global Hawk have capabilities that would be highly relevant in 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.
Kristine Liwag
And when you look at your international customers, as you mentioned lower than your peers, because they’re not exportable. So you’re 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.
Kathy Warden
Well the good news for us is those 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 need to outpace the domestic growth. We’d have to grow international 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 portfolios, we have the breadth to support both, and that’s exactly what’s on our agenda.
Kristine Liwag
Great. And following up what 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 1 uncrewed combat fighter. So how do we balance the sunsetting portion, the export opportunity and these new emerging unmanned priorities?
Kathy Warden
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 its most modern capability as it – then it is going to be replaced with the next generation of capability, like will happen with unmanned systems. They are more open, the U.S. to us 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 long 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 is still composite structures, all lend credibility to our ability to compete for those sixth-generation aircraft as well, both manned and unmanned.
Kristine Liwag
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?
Kathy Warden
Well, we think as we look at sixth-generation aircraft, we are developing the first sixth-generation aircraft in B-21 that has many of the characteristics that I just outlined. And so our experience both working with fifth-gen, whether it’s manned tactical air or unmanned ISR, the capabilities that we’ve developed in those fifth-gen aircraft are highly relevant to sixth-generation aircraft requirements. And we’re looking to position that expertise both in prime and [sub lows] as we have done in our aeronautic business previously.
Kristine Liwag
Great. Thanks, Kathy. And [phishing gives] the space. Space is now your fastest-growing segment. And your backlog even is about 3x segment sales today in space. So you have GBSD as an anchor program, but also beyond that you have a broader space portfolio. So first, can you talk about other programs outside of GBSD that’s driving growth in the space segment? And then also, we’ve seen the DoD invest in space at a double-digit clip for the past few years. How long can these growth trends last?
Kathy Warden
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 assets and 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 is 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 midcourse defense. So the missile defense protecting the U.S. and that was a $3.3 billion IDIQ award that we received last month.
So all of that is contributing to growth in our space portfolio as well as national security space, which is up 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.
Kristine Liwag
And Kathy, for the space evolution and the space spends of the DoDs are undertaking with the three capitalizations. What innings 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 innings of this kind of recap or is this truly a secular growth? So we could see through the – end of the decade?
Kathy Warden
I would say we will see this through the end of the decade. 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 lifespan 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.
Kristine Liwag
Great. And diving deeper into space, you’ve mentioned all these programs with NGI, you’ve bought GBSD, the Ground Midcourse 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?
Kathy Warden
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 these to be the prime systems integrator. And we’ve had mission knowledge and missile defense of the company for many decades. It’s about bringing those Peace 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, where 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 to position ourselves as a leader, not just a peace 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.
Kristine Liwag
Great. And now switching gears to 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 line 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?
Dave Keffer
Sure. That’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 and some of the key domains of the company. And so the 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 is 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’s represents a nearly doubling of the dividend in the last five 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.
Kristine Liwag
And Dave, in that 15-year period when you guys prioritized more buybacks, we also saw leverage tick up. Is that something that you’re looking into in the next few years?
Dave Keffer
So over the last few years, our leverage had 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.
Kristine Liwag
Great. And maybe Kathy, going back to your strategy, earlier this year you unveiled your – 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 and 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?
Kathy Warden
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 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 success and that will help our business grow. Growing profitably for us is about risk reduction by and large. So it’s the way we deliver profitably is through 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 scheduled 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 these same benefits. 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 efficiencies. We are reducing facility and footprint. We are increasing leverage across our supply chain for spend, and we are scaling our operations while minimizing the additional overhead and fixed cost 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 three 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, overseas are also helping our business be agile because we’re laser focused on those four objectives.
Kristine Liwag
Great. Thank you for the color. And switching gears to ESG, I mean, defense at ESG, is it really oil and water or 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’ve you exit specific contracts. You’ve named a 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?
Kathy Warden
Well first, it hasn’t changed my view at all about the need for a strong deterrence and a 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 that as much as we all would like to 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 deterrence 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 – 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 path to 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 aligned 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.
Kristine Liwag
Great. Thank you, Kathy. And so with the time that we have left, we probably have time for one or two questions from the audience. So please raise your hand and we’ll get a mic to you.
Question-and-Answer Session
Q – Unidentified Analyst
I don’t know if this is an ESG question or not, but there’s a lot of talk before Ukraine about hypersonics and the speed of which that really controls a decision or shortens a decision timeframe for command and control of. And so how are you thinking about kind of the ethics 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?
Kathy Warden
We are working with artificial intelligence technologies and we take very serious the responsibilities then to wrap around that ethical AI. How do we ensure that there is positive human control over the artificial intelligence is embedded in solutions, particularly to the extent that they might see weapons control systems? And I will tell you, we have not yet moved to where AI is being used in the weapons control loop. It’s largely being used in autonomy, as we think about teaming of systems and how various systems would cooperate with one and other is 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 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. is being equally cautious. They’re investing in these technologies to make sure that before we would use them, they are risk reduced in that regard.
Kristine Liwag
Craig?
Craig Sheppard
Hi. Craig Sheppard, Apollo. With regard to pension risk transfer, is that something you had have ever considered are looking at things. I know peers have done that recently. Thanks.
Dave Keffer
Sure. We evaluate all of our options regarding our pension plan. As I mentioned earlier, we’ve improved and 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.
Kristine Liwag
Well, great. This is all the time that we have. So thank you, Kathy. Thank you, Dave. And this concludes the session.
Kathy Warden
Thanks, Kristine.
Kristine Liwag
Thank you.
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