Northrop Grumman Corp. (NOC)
Baird 2022 Global Industrial Conference
November 8, 2022 10:05 AM ET
Company Participants
Kathy Warden - Chairman, Chief Executive Officer & President
David Keffer - Chief Financial Officer
Conference Call Participants
Peter Arment - Baird
Presentation
Peter Arment
Thanks, everyone, for joining us. My name is Peter Arment, Senior Aerospace Defense analyst here at Baird, and we're absolutely delighted to have Northrop Grumman Corporation here with us. And with us we have Kathy Warden, who's Chair, CEO and President of Northrop Grumman; and Dave Keffer, who's also the Chief Financial Officer. So before we jump into anything, Dave is going to make a couple of quick comments, and then we'll jump right into Q&A. So thanks.
David Keffer
Thanks, Peter. Good morning, everyone. Today, we're going to make some forward-looking statements. Those statements involve risks and uncertainties and 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 reconciliations of those measures to GAAP measures within our most recent earnings release. So with that, I'll hand it to you, Kathy.
Peter Arment
Go ahead, Kathy.
Kathy Warden
Well, I'll just make a few opening comments because we just reported third quarter earnings about 2 weeks ago and it was a solid report. We have returned to growth, had strong demand signal from our customer, which we converted solid book-to-bill at 1.14 so far this year and expect to be able to end the year well over 1, which is an improvement from where we anticipated being at the start of the year. This is after several years of very strong backlog growth so we go into next year with nearly $80 billion of backlog. We also indicated an outlook for 4% to 5% sales growth next year and continued strong performance across the portfolio, although we did note headwinds, on supply chain and inflation that creates some operating margin pressure into next year. We worked to navigate and mitigate that risk as best as possible and have been pleased with the performance that we've seen in the portfolio this year.
But what Peter, I would really summarize all of that with is, we see these as temporal headwinds against a backdrop of very strong demand for our products and services. And more importantly, as we look out over the future, and even point to some of the recent documents that the administration published around the National Defense Strategy, the Nuclear Posture Review and the Missile Defense Review, it shows how strongly aligned our portfolio and our specific programs are in support of those national defense priorities. So a strong backdrop as we look forward with optimism.
Question-and-Answer Session
Q - Peter Arment
Terrific. So there's a kind of a common theme, I think, post- Q3 earnings, right, in terms of the macro environment and some of the challenges that are out there facing the industry, but Northrop seems to be navigating better than most. So maybe just help us understanding what you're doing differently in this area. Maybe we'll start there.
Kathy Warden
I appreciate the compliment. Our team works hard every day to understand the risks and constraints in our supply chain. And our first objective is to always work with our suppliers, be able to share resources with them, help them to work through any constraints that they have, leverage our buying power, for instance, to enable them to deal with the constraints they're facing.
If we can't do that, then we look to redesign, and we have done that quite a bit this year. And while that is in itself a bit of a delay to our programs, redesigning out parts that are either hard to find supply for or with suppliers who have chosen not to continue doing business in the industry. So we have had some of that. And then finally, we are a supplier ourselves. So I very much understand what is needed to be able to work through some of the constraints that have been created from the macroeconomic conditions.
And as a company, we're investing in capacity to make us a better, both prime and supplier. And good examples of that are what we are doing in our weapons business, where there is clearly a shortage of supply, including in areas like propulsion, where we are building out capacity to offer a second source to the primes that we work with.
Peter Arment
Right. So where are you seeing, I guess, the most constraints within the supply chain? What would you highlight, I guess, there?
Kathy Warden
It's broad-based. And so I've hesitated to call out any one area as particularly material for us. One, we're a highly diversified technology company in aerospace and defense and so any one area for us or even any one program is not significant, but it's the small impact across a broad base of supply components that are the challenge that we're navigating our way through. I frankly wish it were just two or three areas. So we're managing those challenges much easier.
Peter Arment
Yes, I've got to start working that in more Northrop is a technology company because that seems to be coming through evident in everything else that you're involved in. And one of the things I learned is just you have your own chip kind of capabilities. Maybe just give everyone just a quick comment on that because I think that's unique to you.
Kathy Warden
Right. We do own two foundries, and we do our own chip design as well as fabrication in those foundries. And then one of the key aspects of the work we do in the foundry is support those chips for the long term. Once you design something into a weapon system, a commercial supplier often will support that technology for 3, 5, maybe 7 years and then move off that technology.
But if we want to support a weapon system for 20 to 30 years, we have to be able to fabricate those chips for replacement parts well into the future. So our foundries has been a key differentiator for us as an enabler to not only produce very competitive systems in design and development, but also to be able to maintain them for the long term.
Peter Arment
So let's talk a little bit about, I guess, Northrop's strategy and kind of the big picture. How would you describe it? And maybe just as a leader in Northrop Grumman, what do you look to accomplish over the next several years?
Kathy Warden
We've been executing a clear strategic direction for the last three years, and it has started with technology leadership. So we were just talking about how important that is for us. It is our key source of differentiation in the industry that we are building technologies that solve our customers' hardest problems, and in some cases, uniquely positioned to do so. And that's the foundation which the rest of our strategy is built on.
The second element is aligning our investments to areas that's most importance to our customers. And you can see that, as I noted in the recent documents that the administration published around the National Defense Strategy, which highlights areas like the strategic deterrent and space resiliency. These are areas that we have been investing in for years to position ourselves with the capabilities that can address those needs.
And then the third area is to perform and have a laser focus not only on performance but cost efficiency and speed, attributes that our customer highly values. And then finally, capital deployment. And there, we focus on a balanced capital deployment strategy that appeals to both our customers and our shareholders. And what I mean by our customers, they are looking for the kinds of investment that we have put into our portfolio to provide them solutions.
And of course, as investors, you're looking for a return on those investments. And we're very diligent in balancing that capital deployment strategy to pave the way for the growth that we're experiencing, but also generate the returns and cash flow from those investments for our shareholders.
Peter Arment
Well, we've certainly seen it in your backlog. That's for sure. So it's certainly paying off on the strategy front. Maybe just a comment on the budgets, your -- kind of your sales guidance assumes what does that assume with respect to kind of the final fiscal '23 budget? And then just because we've gotten used to it that we always start the year under a continuing resolution, which is not a way to run anything, but maybe you could just give us an update how that affects you, if it affects you at all or affects the supply chain, maybe you give some comments there.
Kathy Warden
Well, you characterized it well. We've gotten used to operating under a continuing resolution, but it is not an ideal way to manage our government. And so we are hopeful that continuing resolution will be resolved this year. But our base assumption is that it will go into early next year. We do see immediate impact if we trip into next year without a budget in place, there will be some headwinds to growth as there always is. Some programs will slow down based on funding constraints as the continuing resolution represents, but it will be modest for our company. Our programs are well funded both in the President's budget and in the committee marks, and we are confident that our customers will be able to manage through a relatively short-term CR even if it stretches into early next year.
What I would say more broadly is that I think the government is acutely aware that in order to address some of their desires for longer lead time capability investment and to increase capacity that the government needs to provide longer-term demand signals. And the Department of Defense is increasingly talking about multiyear demand signal even if appropriations have to happen annually, giving some longer-term planning signals to industry would be very helpful.
Peter Arment
Yes. So I mean, just to stay on the topic of budget just for a second, just -- I think we all kind of view that we're in an elevated budget environment. How are you thinking about that just kind of over this profile regardless of administration, it feels like?
Kathy Warden
It does. The national security agenda is as bipartisan as I see in Congress today. And that's really important, and I think it will be enduring. It is in reaction, I believe, to the threat environment that we are living in, and the citizens of the U.S. has become increasingly aware, partly because of events like the Russian invasion of Ukraine, but also just generally more aware of the importance of security and safety. And so as that has happened, again, there's been strong bipartisan support in the last couple of years for the increases in defense spending. And I see no indication that, that's turning as a matter of fact the intensity around a desire to move with urgency to not only help allies like Ukraine, but also to position the U.S. with stronger national security capability is at the forefront.
Peter Arment
That's helpful. So -- just you mentioned Ukraine. So there's an increased demand for munitions, missile defense capabilities. How does that fit in to Northrop Grumman? What are you seeing there? And you can weave in space associated with that I'm sure that there's some draw there as well?
Kathy Warden
We are seeing some near-term demand for things like our cannons like the Bushmaster Cannon or ammunition like the SAWS program. And we are working with primes where we supply propulsion on programs like GMLRS. So all of that, we are seeing immediate increase in demand signal. But it's not significant and it will take time for the government to determine how much they want to replenish stockpiles of those weapons and what that demand signal looks like into '23 and '24. Where we're seeing the most interest in long-term increased demand is in programs like IBCS, which is a missile defense system. And there, we've seen half a dozen countries in Europe expressed interest just in the last 10 months. And so those will take even longer to develop into sales. That's a 2- to 3-year proposition, but those are much larger opportunities for our company.
So we really see this in multiple epics. The first is the near-term demand signal that we're getting, and we're supporting capacity increases in those ammunition programs. The second is more in the defensive capabilities like counter UAS and missile defense, and we see that as a more long-term proposition.
Peter Arment
And you mentioned to me just about this theme of just kind of keeping lines a little bit more warm for the longer term. Maybe describe that just for a second because I think that is something that's not well understood.
Kathy Warden
Yes. The U.S. government has come to the realization that for weapons in particular, but this applies broadly across the systems that very choppy demand signal where we build up stockpiles, we wait for an event to deplete them, and then we look to replenish them quickly is not an operating model that is going to make sense, investment in capital for industry will not work in that kind of model. And they're very inconsistent demand signal will result in production lines being shut down. So there is a view that there needs to be a more smooth demand signal and that if that means the U.S. government is building up inventory or stockpiles that they will do so rather than take the risk of not having what they need, if a conflict were to break out like we've seen in Ukraine. So I think, again, this goes back to the point of having not only more consistency, but more longevity in demand signals to industry.
Peter Arment
Okay. Let's move over then to just your growth, you provided 4% to 5% growth for next year. AS is going to return to growth in 2024, really aided by the B-21. And as expected, I think you're going to see continued growth in Space and MS. So the consensus has kind of growth for 5%-ish. Is that the right way to think about it? How should we think about that?
David Keffer
So I can jump in on that one, Peter. As you know, we've guided now 4% to 5% growth for '23. We haven't provided specific guidance beyond '23, but we can touch on some of the macro factors and then some of the bottoms-up factors that will influence that growth rate.
At a macro level, Kathy has touched on both the strong demand environment, our tight alignment with the priorities in the demand environment these days, both domestically and internationally as well as the backlog growth and success we've had in our book-to-bill this year closely related to the strength of the demand environment these days. And so we anticipate that those factors will remain in place over the next several years.
Yet to be seen is the pace of easing in some of the supply side pressures that we've also talked about today. We've noted that in '22 and now in our expectations for '23, our growth rate would likely have been higher, if not for the disruption in the supply chain, the challenging labor market conditions that are now beginning to ease, and we've demonstrated some strong headcount growth over the last couple of quarters as a result. But certainly, these pressures continue, and we anticipate that they'll continue in '23. So the pace of easing of those as we look at '24 and beyond will be another macro factor we'll closely monitor.
At a micro level, certainly, when we look at our businesses, the opportunity exists for our Space business to continue to be our fastest-growing business over the next couple of years. Its backlog growth has been tremendous. The market is growing rapidly in the space domain, and I think we're gaining share in that market, really across mission areas, across domains and across customer sets between our National Security customer set and on the civilian and even in pockets of the commercial market as well. You noted we've projected that our Aeronautics business will return to growth in 2024. Opportunities exist for growth in all of our sectors in 2024.
This year has been a year of book-to-bill over 1.0 in all four of our sectors. That's certainly a good leading indicator and one that gives us optimism as we think about multiyear growth.
Peter Arment
Terrific. And then Dave, I just want to stay with you on for a second and just on AS. So maybe just help everyone understand how the B-21 transitions a little bit, just so everyone understands kind of that growth profile?
David Keffer
Sure. So there's a limited amount we can say about the details in the budget profile and quantities and all the rest on the B-21 program. But we have noted on our last few earnings calls a bit more than we've been able to in the past. And it's because we're now moving through the EMD phase, approaching the low rate production phase a full rate production phase will exist beyond that. And so we've talked about over the next couple of quarters, the transition into the low rate production phase with EMD continuing. .
We have the rollout on December 2 that obviously, a lot of public disclosure has been made and there's a lot of excitement around the industry and the customer set about that rollout of the first aircraft on December 2. We will then continue with the kind of overlapping transition into low rate production and full rate production begins later in the decade.
Peter Arment
Terrific. I was going to ask about the rollout, so I'll just ask it anyway, Kathy, because I know there's not a lot you can say, but it is pretty exciting. So maybe just for those who aren't aware, December 2, maybe you could just let us -- everyone know what's going to happen.
Kathy Warden
It will be the public unveiling of this magnificent aircraft that we've been working on for a number of years, and it's an opportunity for us to celebrate the U.S. Air Force, the Northrop Grumman and supplier teams that have built the aircraft and to show it. And what it does mean is that we have an aircraft that is progressing quickly into its flight test milestones.
And then, as Dave said, will transition into production. But we are still laser focused on completing the test program successfully and getting the new aircraft builds underway, and we will not be happy. Our big milestone of celebration will be when we start to hand over these jets to the Air Force to support their strategic deterrence mission. So a lot of work still ahead of us, but a big milestone to have a finished test article that is ready to continue progression through test.
Peter Arment
I don't think a lot of people understand that. I certainly did that this is a production-ready aircraft. Maybe you could just describe that.
Kathy Warden
It is. So this first aircraft that we will unveil is a test article. And so it will not be used by the Air Force, the production jets will, but the real milestone here is that we have built the test article to be a production representative aircraft. So unlike many programs, the test article would not actually meet the requirements of what you would produce and hand over. There are waivers, there are things that are still left to be done in building out the structural integrity of the aircraft to meet the full requirements.
We have built in conjunction with the Air Force, a production-ready jet for testing. So it will smooth the progression from this development phase into the production phase and reduce the risk that has been inherent in prior aircraft development programs during that phase.
Peter Arment
Feel terrible going transitioning from the B-21 to talk about margins, but I'm going to ask anyway. So supply chain, inflationary environment, you've got a 20 basis point headwind on margins next year. Maybe you could just talk about some of the actions you're taking at the segment level and how that will transition over time.
Kathy Warden
You want to talk to that?
David Keffer
Sure. I'm happy to touch on that. So when we think about our margin profile, it's driven by a few factors. One is the mix of business. Today, we have about 50% cost-type work and about 50% fixed price. The more fixed price you have tends to create margin opportunity. And so we carefully track that mix in our business. We do expect over the next few as we get to the middle of the decade that the mix will shift gradually in the direction of more fixed price work.
But equally important, our program performance and our cost efficiency, both in the way we manage the business and the way we execute our work. And as you noted into 2023, we're anticipating about 20 basis points of margin compression, largely because of the macro environment reactors that we're facing and that every industry is facing these days around cost escalation and inflation both in the workforce and the supply chain. So how do we mitigate and manage that? Certainly, it's a laser focus on our supply base. Kathy, as noted earlier, the tight partnership that we have with our suppliers to try to manage through the challenging environment. We try to give them as much lead time as we can to manage through potential disruptions.
But then certainly in the way we execute and drive margin efficiency, drive cost efficiency, that too has a benefit for our margin stability over time. And a lot of that relates to the way we execute in terms of our digital transformation. We're progressing well through a multiyear digital transformation journey that involves both the way we digitally kind of manage the business as a whole and then execute our work from the design and development phase into engineering and production phases through a digital thread that reduces risk, reduces time associated with our programs improves cost and schedule performance.
Peter Arment
Kathy, does that -- do you feel that gives you a competitive advantage, the digital transformation? It seems like it's a pretty important factor.
Kathy Warden
I do. I think many companies will move in this direction, but we do have a head start. We've been doing it for a number of years. We're over halfway through a 5-year plan that we laid out. And more importantly, we've been able to utilize digital enablement on these big programs in their development phase. I've already talked about the benefits that we've derived on the B-21 from digital enablement, Sentinel or GBSD, we say it was born digital.
We had already laid in a lot of the digital enablement. I've talked about leveraging on B-21 from the start of the Sentinel program. And those are two big programs that we talk about often and have more visibility, but there are hundreds of smaller programs that are getting the same benefits from the investment that we've made in the digital infrastructure.
Peter Arment
Terrific. Capital deployment third quarter earnings call committed to return 100% of free cash flow to shareholders of next year. And repurchase, I guess, are going to be slightly higher than this year's level, which is $1.5 billion. How should we just think about those plans? And then weave in your thoughts on the R&D amortization law, any scenarios there?
David Keffer
Sure. So our top priority for capital deployment continues to be reinvesting in the business in terms of the CapEx that drives differentiation that facilitizes our business, provides the tooling and equipment needed to continue to differentiate and grow the business. And with the more rapid than expected backlog growth over the last few quarters, that capital intensity continues, and we continue to be at peak levels around the 4% of sales level or slightly higher. As we think about kind of this year and next, before coming down over time, maybe towards the 3% range that we've projected over a longer period of time and a more normalized capital environment.
So when it comes to our free cash deployment, we do think of a balanced approach between a competitive dividend. We increased our dividend by 10% this past spring and continue to do everything we can to maintain a healthy dividend posture. And with the remaining cash available these days, we do look to return that cash to shareholders in the form of share repurchases. We've committed to $1.5 billion or more this year. The opportunity does exist next year to increase that level. Certainly, our base case scenario assumes to your last point, Section 174 relief, where the R&D tax law would be deferred such that we'd be able to continue to expense our R&D costs as opposed to amortizing them over a period of 5 years.
And so that's one item that will influence the volume of available cash. A refund could further increase our cash available to capital returns. But I think that gives you a sense for the prioritization around shareholder returns of 100% or more of our free cash flow.
Peter Arment
Terrific. You mean on the CapEx just because I think about all the growth that's in front of you, maybe just no incremental CapEx you've been leading facilitizing a lot of this effort for quite a while. So how do we just think about new opportunities for growth CapEx? Is there any big requirements?
David Keffer
Sure. So we've noted on the last couple of earnings calls, as we've increased our book-to-bill this year, our book-to-bill expectations in large part given by competitive new wins in excess of what we even anticipated and planned at the beginning of this year. Some of those do come with some early capital requirements. An example would be the propulsion support for the Amazon Kuiper installation where we're supporting our prime in that endeavor. That's a large volume over a number of years that does involve some tooling and facilitization up front. And so that and other recent new business wins, particularly in the Space business, but really across our business, lead to some increase in CapEx requirements over the next couple of years. That's on top of the existing requirements associated with B-21 and GBSD and other large franchise programs.
So that's what I mentioned kind of continuing at a peak level or even slightly ticking up. That's the environment that's causing that. It is driven by outstanding backlog and book-to-bills, not just this year, but over the last 3 years that are creating the need for incremental capacity.
Peter Arment
Yes. It's kind of CapEx that I think everyone likes to see.
Kathy Warden
Absolutely.
Peter Arment
So you mentioned Space. I can't lay off stage without asking about Space. It's grown by another $1 billion here as we get into next year. And I guess, it's going to be ultimately your largest business, which is incredible to think about. Just maybe how do we think about that growth and the margin rates in this business longer term?
Kathy Warden
Yes. We do expect space will continue to be both our largest and our fastest-growing business into next year, about $1 billion of incremental sales. A little less than half of that will come from the Ground-Based Strategic Deterrent. And the remainder comes from major programs like NextGen Interceptor, our restricted space growth, our two wins this year with the Space Development Agency. And what I really characterize is fueling that growth is we now have a portfolio that can work within our customers' vision for space assets that are highly exquisite and capable to ones that are more about volume and resiliency in low earth orbit, and those are two very different types of architectures for space asset to perform particular missions in whatever direction our customer wants to move in, we're able to provide them a portfolio with depth of technology that can enable it.
And so that's what we've really demonstrated this year, both the breadth of the portfolio and our ability to pivot with the customer as they think about new and exciting ways of deploying space assets.
Peter Arment
Terrific. Well, we've got two minutes left. So I'll ask on ESG just because I know a lot of people care about it, and we certainly care, and defense companies are all doing a lot of things to support those efforts, but at the same time, a lot of things have changed since the Ukraine invasion and energy crisis. So how are you -- how does Northrop Grumman think about this? And are you seeing a shift actually in your shareholder base related to this?
Kathy Warden
We are. We are seeing more interest, particularly with the banks in Europe expressing interest in getting to know our portfolio better and understanding what's in it and how we think about the governance of this important portfolio. I would say it's something I've always believed, which is that there is no more noble work then supporting the tools and deterrence that create global stability and promote freedom around the globe.
So I believe that our portfolio is used by nations that are peace-seeking and that use the portfolio to stabilize not to drive toward conflict as a desired outcome. And with that in mind, I can feel very proud of the work we do. And I think more and more investors are looking at the portfolio through that lens. If it can be helpful in protecting the people of Ukraine, who is just trying to peacefully exist in their homeland, have been attacked on their own soil, then there's good in that. So that's the portfolio lens. But we also know that we need to be good corporate citizens and that as a manufacturer, we have responsibility for environmental protection. So we have aggressive environmental goals that we've established for the company. I'm proud that in executing those goals, we already have had a 40% reduction in our greenhouse gas emissions from operations in the 10 years that we've had goals in place, but we want to get more aggressive. And so we've established a 2035 goal for zero greenhouse gas emissions for our operations, that's Scope 1 and Scope 2 emissions.
We have had and continue to have a focus on diversity, equity and inclusion and a broad-based social program that focuses on enabling supporting our communities and drawing more talent of diverse backgrounds into our industry. These are all things that we're doing to be good corporate citizens, while at the same time, providing a portfolio that help governments protect their citizens.
Peter Arment
That's a terrific way to end on, and I appreciate Kathy and Dave your support of the conference and thanks for joining us. Appreciate it.
David Keffer
Thanks, Peter.
Kathy Warden
Thanks, Peter.
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Northrop Grumman Corp. (NOC) Presents at Baird 2022 Global Industrial Conference (Transcript)