NOC - Northrop Grumman Corp (NOC) 2023 Morgan Stanley's 11th Annual Laguna Conference (Transcript)
2023-09-13 13:57:05 ET
Northrop Grumman Corp. (NOC)
Morgan Stanley's 11th Annual Laguna Conference
September 13, 2023, 11:10 AM ET
Company Participants
Kathy Warden - Chairman & Chief Executive Officer
Dave Keffer - Corporate Vice President and Chief Financial Officer
Conference Call Participants
Kristine Liwag - Head of Aerospace and Defense Research here at Morgan Stanley
Presentation
Kristine Liwag
Hi, good morning everyone. I’m Kristine Liwag, Head of Aerospace and Defense Research here at Morgan Stanley. I'm very excited to host our next session, so we have Kathy Warden, Chairman, President and CEO of Northrop Grumman, and Dave Keffer. Thank you for joining us today.
Dave Keffer
Thank you.
Kathy Warden
Thank you.
Kristine Liwag
And before we begin, standard disclosures for important disclosures, please see the Morgan Stanley Research Disclosure website at www. MorganStanley.com, forward/research disclosures. If you have any questions, please reach out to your Morgan Stanley representative. And with that, we'll kick off on to Dave.
Dave Keffer
Sure, thanks Kristine. Speaking of disclosures, today we're going to make some forward-looking statements. Those statements involve risk and uncertainties and information about those risk and uncertainties can be found in our SEC filings. So with that I'll hand it over to you for some comments, Kathy.
Kathy Warden
Great, thanks Dave. Thank you Kristine for having us. So it's good to be here with you. I thought I'd make a few comments about highlights in the business and then turn it over to you for questions and answers.
As we continue to execute our strategy to sustainably and profitably grow the company, we are experiencing strong sales growth, 7% so far this year, and we're projecting 5% to 6% sales growth this year at the midpoint of our guide. As we look at our opportunity to expand margin, we spend some time in our second quarter call, laying out a clear plan for margin expansion over the next several years, and we'll talk some more about that today. I'm sure that the key point is that that margin expansion also leads to free cash flow expansion. We are targeting 20% compound annual growth on free cash flow in the next two years, so through 2025 and the doubling of free cash flow from our 2023 expected levels by 2028. This gives us a good bit of opportunity to think about capital deployment. Of course we in the last few years been investing in the business to support the growth and demand that we see from our customers today. It's positioned us well and is contributing to that top line growth I talked about.
But we see that coming to a point where we can gradually decline in our investment in the business and still have healthy support to the portfolio growth and execution. As we do that, it will allow us to look at shareholder returns as we have in value creating ways in the past. This year we are returning 100% of our free cash flow to investors. We have about 1.5 billion of share repurchase planned for the year, much of that already executed and once again this year 20th consecutive years as a matter of fact we have increased our dividend share with an 8% increase in May. So this time the strong demand signals we’re seeing how well our portfolio is aligned with what our customers need both in the U.S. and internationally, a clear path for margin expansion with free cash flow expansion and an opportunity to return that as we have had a long track record in ways that are value creating for shareholders. We’re really excited about where Northrop Grumman is positioned.
Question-and-Answer Session
Q - Kristine Liwag
And you know, Kathy, that that growth is really outside versus the top line for the DoD. When we looked at, after the debt ceiling negotiations we've seen a 3% cap in the fiscal year 24 DoD budget. And 1% cap for fiscal year 25. But from everything that you described I mean you're really looking at a mid-to-high single digit top line. Can you help us bridge what this budget area environment needs for you? And then will your portfolio is outside to sustain this higher than top line growth environment?
Kathy Warden
Well, we're pleased that the Congress came together and put in place the fiscal responsibility act, of course it did impose the caps that you've spoke of. But as we look at the strong bipartisan support for national security spending that certainly indoors. The President's budget is well aligned to the priorities that have been laid out in the national defense strategy and those priorities in turn are well aligned to our programs. So when you decompose the budget, even though it's a top line within those 3% cap, you look at areas like the investment counts, which are growing faster than the 3%.
And then within that, you look at programs for the nuclear modernization where we have significant exposure on B-21, Sentinel and Columbia, that's over 10% growth. You look at space where we have significant growth. We've been growing that portfolio at 17% year-to-date that too in the budget is well supported. So when we line up our programs in portfolio against that budget, we see the opportunity to grow faster certainly than the 3% cap.
I also thought it would be remiss if I didn't mention we have a strong backlog, which also will support forward year growth our backlog sits at 2x sales. And international is additive to the U.S. defense budget. And when you look, particularly at Europe, with the NATO countries, ex U.S. or excluding U.S. budget growth, it's expected to be in the mid-teen. So all of this creates an environment where we're confident that we can continue to grow the top line.
Kristine Liwag
Thanks. And the long-term viability of these programs are increasingly clear, as you mentioned, for the support from Congress. But in the near term, continuing resolution has been the norm, I guess, versus the exception, and what we've seen in the past 15 years. This year, there seems to be an incremental risk where if Congress isn't able to pass all the bills by calendar year end, there's an automatic 1% cut to government spend. So how do you think about that risk playing out in the shorter term, and the risk of a prolonged CR, more than we've historically been used to, which is on average about 100 days?
Kathy Warden
So our base case is that the continuing resolution will not extend beyond year-end. As I mentioned, we see strong bipartisan support for national security spending. I think the Congress, on both sides of the aisle, understand that the negative 1% holdback would be detrimental, not only to our national security, but not having timely appropriations, is detrimental as well.
So there is clear drive for Congress to come together and resolve differences and get appropriations passed by year end. There is the possibility, and I'd say this year, it's a little higher than other years, of a short government shutdown. And so we're prepared for that. Our industry is generally able to work through those shutdowns, and we have, as you noted, been through both shutdowns and continuing resolutions before. I don't see them having an outside impact on our ability to deliver our plan for the year. It's just simply a matter of managing through these challenges that, unfortunately, was coming up to them too.
Kristine Liwag
Great. And on the July earnings call, you talked about margin expansion, and I think a lot of investors were pretty excited about that, because historically we haven't seen top-line growth and margin expansion in defense, usually one of the other. So in a period with what we're having both, you had highlighted macro stabilization cost management initiatives in the portfolio mixture. Can you quantify for us the three different buckets and size the opportunity for margin expansion?
Kathy Warden
Well, certainly, when we talk with shareholders again at the end of our third quarter, we generally provide some guidance as we look into 2024 on trends, and we'll provide some more clarity. But we have said we expect that margin expansion to continue through this year as we move into the second half of the year and into next, but more pronounced in the later parts of the decade. And it's because the macroeconomic stabilization is starting to take hold now. We're seeing those impacts. Certainly, our work with cost efficiencies are starting now, but they too will continue to unfold in future years and grow as we launch and complete more of the initiatives under our digital transformation, our facilities optimization, our supply chain optimization, just to name a few of the major categories in that cost management program that we've launched.
And then finally, when you think about mixed shift that is the largest contributor to margin expansion. That's our current development programs moving into production phase, maturing through production, which generally each step of that life cycle drives higher margin opportunity, and growing our international portfolio. As I noted, we expect our international growth to outpace domestic growth, being in the double digits, and that, too, will be a contributor to higher margin as that work performs at a higher margin rate than our domestic. But those things will be a bit more gradual and take time and have the largest impact toward the end of that five-year timeframe that we've been talking about.
Kristine Liwag
And so how quickly do you think you can get to the 12% margin target?
Kathy Warden
Well, that target, we put out there over this planned period that we just talked about. And so we see gradually working our way to that target over that timeframe.
Kristine Liwag
The B-21 has been a program that has been under pressure on the margin. The low-rate initial production was fine in the period before this inflationary environment that we've seen today. So where are we now on the B-21? And you talked about a potential but improbable likelihood of a $1.2 billion loss for the program. Where is it today now that inflation is more or less stabilized?
And then second to that, you received a $60 million inflation relief from the DoD for the program. Is this something that could potentially offset this potential loss that you had previously highlighted?
Dave Keffer
Sure, Kristine. I can touch on that one. The inflation relief you mentioned is one of many assumptions that we make going forward about the cost profile, the contract profile of the contract. And we update those assumptions on a quarterly basis, as we've been talking about since the beginning of this year. And we update the disclosures accordingly. We'll continue to do so going forward. I think what you should have your eyes on in this program is the big picture. And as it relates to the long-term health and success of the program, you heard as recently as yesterday, the customer talking about the success in the testing phase of the program to include most recently the engine run phase of that testing program, which is continuing to keep us on path for our first flight this year. That's something our team is excited about. It's an important milestone, of course, for the program.
And so long-term health of the program will be dictated by the ability to deliver that critical capability to the warfighter to do so at an efficient cost and deliver value to the customer. And we think over time, that's what will help deliver mutual value both to the government and to the company.
Kristine Liwag
Great. And maybe on the contracting environment, right, there seems to be higher scrutiny from the Department of Defense about pricing. I think we all saw the defense contract finance study, the 60-minute segment on defense and the pricing environment. But at the same time, the industry's got some scar tissues on fixed-price development as we've seen in portions of portfolios across all the different primes in the past few quarters. So how do you balance this pressure from the government customer on pricing versus managing your risk and lessons learned for example, like the B-21?
Kathy Warden
Well first I would say that our industry is not unique in that kind of pressure. And these cycles tend to ebb and flow. And so being in one now, we have a shared interest with the government. We want taxpayer dollars to be used effectively and efficiently. But we also want our investors to get a fair return on their investment. And so it's about balancing that risk and reward. And it has to be done contract by contract, certainly because it's based on the assessment of what that risk is. On a contract that has a very long duration, as we have seen, macroeconomic factors are unpredictable over very long periods. And so we have learned that we need to safeguard against those, and we're applying those lessons that we have from our B-21 experience, and that frankly, everyone in industry has from this recent period. But at the same time, I like to zoom out and think about what is unique to this industry and what has it caused over time. I think there is very little that's unique to our industry. We like every industry, are exposed to macroeconomic factors. We need to protect against those. We need an appropriate risk-reward structure with our customers, and part of that is helping to educate our customers on what is important to industry and what drives our returns.
And we work to do that, and periods like this can actually give us an open door, an opportunity to have those discussions. And so we certainly are taking advantage of that. And as I look both historically and to the future, these moments in time don't have a lasting impact on the economics of the industry. Our industry has been able to get through these moments in time and swing the pendulum back to a better balance of risk, and I think we're certainly working to do that now. And as we do, I'm confident in our ability to continue to drive strong margins in this business.
Kristine Liwag
Thank you, Kathy. And you recently noted, and which probably took industry by surprise, the decision to not bid as a prime on the Next Generation Air Dominance Program, NGAD. So when you think about the decision to not bid on NGAD, I mean is it to avoid winner's curse potentially? But is there anything specific about the technical requirements, the structural requirements, or the contracting environment for NGAD that makes the risk-reward less favorable for Northrop?
Kathy Warden
Well we spoke to the Air Force, and I will leave that conversation private between us and them about the reasons why we chose not to pursue that opportunity as a prime. We are offering our capability as the mission system supplier. It's an important capability for the warfighter to have access to, and so we are offering it. But it does go to that risk-reward profile I talked about and discipline on our part to have those conversations with customers when we see that balance not be aligned to both interests. And it also goes to our overall assessment of what to pursue when we are well-positioned, when the return on investment, and we look at that very seriously. All of these military aircraft programs are capital and investment intensive, so we want to make sure that we see a fair return on that investment, but also that it is a time where that strategically fits with what we want to be investing in.
And there are, as you know, a number of other opportunities in military aircraft, so we looked at this decision not just as a standalone decision with regard to the Air Force NGAD, but across the collection of opportunities that we might pursue.
Kristine Liwag
And I guess also to highlight, it's not the first time you guys have walked away from a prime, like I mean, T-7 contract, right?
Kathy Warden
We have remained very disciplined. We chose not to bid the second tanker. We bid and won, actually, the tanker program, but when that was overturned in protest, restructured, went six-price development, we told the government how we felt about that, and they continued on that path, and we ultimately chose to no bid. T-7 it’s another good example where we chose to no bid. So we do remain quite disciplined. It's the only way that you can have an effective voice in shaping how customers think about that reward risk profile, and so our company has a track record, and you can expect to see that behavior from us going forward.
Kristine Liwag
And despite not bidding as prime, you've talked about the opportunity as a subcontractor to the program, but you've also suggested your bid on the NGAD platform, the FAXX, and the Air Force's Collaborative Combat Aircraft, the CCA program. Can you talk about the opportunities there? What does it mean to be a subcontractor? Where do you see your competitive advantage, and how large of an opportunity, potentially this could be for you?
Kathy Warden
Well, we've talked about being a supplier on the Air Force program, on CCA and FAXX. We are participating as a prime. The Navy has confirmed our involvement in that program and started to release a bit of information about it, and that's when I talk about this collection of opportunities. Our company has a very broad portfolio, so we can grow. It's top of class, even with making some no-bid decisions, and we think about that in a disciplined and strategic way. Both FAXX and CCA are ones that we are currently involved in and very excited about how our capabilities align to what the Navy, in the case of FAXX, are looking for. Our experience on B-21, we think, is highly relevant. We've been involved in tactical fighters in both the F-35 and F-18, and we have spent a lot of time producing and building aircraft ago onto the aircraft carrier deck for many decades. So well positioned there and with CCA, of course that is an autonomous aircraft. And I would say our expertise and experience there is unparalleled when it comes to not just remotely piloted, but truly autonomous vehicles. And we think that experience will be fruitful for the Air Force to leverage.
Kristine Liwag
Yes, I forgot my X-47D [Ph] Aircraft pen. I was going to wear that today.
Kathy Warden
We got to get you B-21 pen.
Kristine Liwag
That would be great. And space. We talked a lot about six generation aircraft in the future of the Air Force, but space has been a highlight for the DoD spend. You've talked about double digit annual growth this year. How sustainable is this growth profile for the portfolio? And we've seen like 20% plus increase in the space spend when the top line is only up 3%. How far along are we in the innings of bases and endmarket?
Kathy Warden
Well, that portfolio has grown not only 17% year-to-date, but 17% from 2019 to the midpoint of our guide for that business this year. So over a long period of time now. So with the risk of losing credibility, I'll tell you that I don't expect that we'll continue to see 17% growth in that portfolio going forward. As we now are growing off of a larger base, and some of the key drivers will naturally have a slower growth rate like Sentinel. But on the other hand, we do still expect that business to be our fastest growing. And there are still many programs that have a nice ramp ahead, including our space development agency contract and both transport and tracking layer. We just announced another reward there for more satellites in the transport layer. We also are expecting growth out of our Amazon type or contract to provide the Gem 63XL propulsion. We also have still strong growth in our classified space portfolio ahead.
There are many growth drivers still left in that business and wants to be optimistic about. But we've also said that our growth going forward will be more balanced across the portfolio with AS and DS returning to growth next year. We expect and then MS continuing to grow our whole portfolio will be contributing to the top line growth of the company.
Kristine Liwag
Great, thank you. Margins from space. You're guiding to 9% margins of space. You've suggested that this could ultimately be at 10% plus margin segment. So can you talk about how that shifts from development work, heavy, that you have today to fix prices. And one of the buckets of the margin expansion you highlighted earlier. And how much of the transition of Sentinel plays into this mix?
Dave Keffer
I can touch on that one Kristine. The space business is really a microcosm of the company as a whole. When you think about the three buckets of margin and expansion opportunity that we touched on earlier. Certainly the easing of some of the macro pressures that have influence our space business as much as or more than some of their other businesses. Given the predominance of early stage development work, starting up in that business and really ramping over the last couple of years. So the easing of those pressures creates opportunity for our margin tailwind going forward. We are keenly focused on cost management in that business as well, but the largest bucket for the company as Kathy noted earlier is also the largest bucket of margin expansion opportunity for space. And that is the shift from development work toward production work over the remainder of this decade.
And in that category, you can imagine given the backlog expansion we've had in the four plus years of 17% CAGR that we've had in that business, the amount of early stage development work today. The pace of that work transitioning to production will be similar to the pace of margin expansion opportunity that we see as a result programs like Sentinel that will transition later after larger and longer more complex EMD phases as well as other programs that will transition earlier some in the restricted side. Others that we've talked about expanding to include the FDA programs as they transition into larger scale production in the coming years and programs like Amazon type or propulsion support all create opportunity at different phases over the next several years.
So in aggregate, we see more margin expansion opportunity in the space business than our other sectors. It is a business that has operated above 10% in recent memory. It's not unheard of to get it back to that level and so we're optimistic about our ability to do so over time as we see these transitions in the business.
Kristine Liwag
Switching over to cash. Kathy has talked about a pretty chunky 2028 free cash flow step up. But also in the near term 100% free cash flow generation return to shareholders. Beyond 2025, it seems like there should be a fairly large acceleration of cash as investments come down and R&D tax pressure also ease. How should we think about longer-term capital deployment priorities?
Dave Keffer
You know over the last couple of years, we've been talking about a set of free cash flow headwinds, and you've probably been waiting for the point where those would become tailwinds. And we're fortunate now to be in a position to be able to talk about those over the next several years as tailwinds. Over the last few, we've had much lower CAS pension reimbursement. We've had higher capital intensity as a result of the ramp-ups of some of these very large programs we've been talking about. And then cash taxes have grown, largely because of the Section 174 R&D tax amortization.
We now over the next five years will see each of those trends reverse. Certainly, the 174 tax headwind becomes a tailwind each year through the five-year amortization period. Capital intensity should become less. We've talked about that in the 4% to 4.5% of sales range in this peak period of investment in critical programs that we're facilitating and adding capacity for the future. A more normalized run rate is around 3% of CapEx to sales, and so that's where we anticipate returning over time. And then on the pension side, that should be fairly steady or even slightly increased over this period in terms of the cash reimbursement through our programs.
So when you add those to the earlier kind of operational points that we talked about with growth in the top line combined with margin expansion opportunity, as long as we can continue to manage working capital as well as we really have over these last few years delivering best-in-class working capital efficiency metrics, we're really excited about the opportunity that that provides for the 20% pre-cash flow CAGR we've talked about through 2025 and the doubling from around $2 billion of free cash flow in our 2023 guidance to the $4 billion range over the five-year period. And that growth opportunity continues beyond that period as well.
So we've reached that inflection mark we're excited about and looking forward to delivering that. On the deployment side, of course that creates a tremendous amount of opportunity and flexibility. We're comfortable with where our balance sheet stands. We don't have anticipated contributions required for our pension program given that it is very well funded, over 100% funded today. And so that gives us opportunity to even further our shareholder returns beyond the significant levels of the last couple of years. And we've, Kathy noted the dividend expansion we've been delivering, that should create opportunity for that to continue and healthy volume of share repurchase activity as well while we look at the M&A markets and consider the opportunity set there. So it does create a nice opportunity for a variety of different types of capital deployment in the second half of the decade.
Kristine Liwag
You touched on M&A there, so I'm going to dig a little deeper into M&A. In 2018, Northrop bought Orbital ATK, and in hindsight, I mean what a phenomenal acquisition. I mean, transformed the space portfolio and also investing in a period where space spending from the DoD was really just starting to inflect. So in hindsight, it really showed the forward thinking at Northrop. And since we've seen Aerojet Rocketdyne we acquired, Ball Aerospace Space Business acquired and, really proven out for the space thesis.
So as you look at the portfolio today, where do you see gaps in capabilities or potential strategic interests that could have been the space of 2018 and really continue to have Northrop's portfolio outgrow overall top line?
Kathy Warden
Well, the good news for us is that we did make the acquisitions in space and weapons at a time when those businesses were not commanding the premiums that they are today. And so we've been able to get a strong return on that investment and the synergy that we had expected because we were on the early end of the cycle of growth for both space and weapons. And so we now look and don't see a significant gap in our portfolio as we identify the priorities in the national defense strategy, investing in our company, which we have been doing, is allowing us to continue to grow the company at pace and feel if that's a lower risk position for us right now in terms of where to invest. We keep our eyes open, we partner extensively, and that's always a good first step and precursor to thinking about M&A activity. But for right now, we're really confident in the portfolio that we have and the flexibility that we will have in the future if M&A does make sense.
Kristine Liwag
Great. We’ll have time for one question from the audience. If you want to raise your hand, we'll give you a mic. If not, it's okay. I have more questions. No pressure. Quiet crowd.
Kathy Warden
We can have a meeting with most of them later today. So get another shot.
Kristine Liwag
So Kathy, this is a question I'm afraid of asking, because you probably see a lot of things, especially with national security. But what keeps you up at night?
Kathy Warden
Well, Kristine, we are on the cusp of delivering some of the most important and advanced capabilities the world has ever seen. Some of it we've already delivered, like the James Webb Space Telescope. We've unveiled the B-21, but we will actually deliver that to the warfighter in the coming years. And then there are many areas in our classified portfolio that I can't specifically talk about that are equally important and interesting for global security. And while I try to sleep at night, I do spend a lot of time thinking about how we stay on that leading edge of innovation. Our company's value has largely been driven by technology leadership, and technology leadership that our customers can't find in many places. So staying at that forefront is important, not just for value creation for our shareholders, but for global security. And I take very seriously that our customers have entrusted that responsibility in us, and that there are people all over the world looking for the capabilities we provide in the U.S. military to support their homeland protection, deterrence against aggressors, and just helping them to feel safe sleeping at night. So if that results in some sleepless nights for me, I feel like it's really well-placed.
Kristine Liwag
Well, great. Well, thank you very much, Kathy. Thank you very much, Dave. And this concludes the presentation on Northrop Grumman this morning.
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Northrop Grumman Corp (NOC) 2023 Morgan Stanley's 11th Annual Laguna Conference (Transcript)