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NOC.N - Q2 2023 Northrop Grumman Corp Earnings Call

EVENT DATE/TIME: JULY 27, 2023 / 1:00PM GMT

OVERVIEW:

Company reported free cash flow of $1 billion, cash of $600 million, free cash flow of $600 million, cash of $360 million, free cash flow of $3 billion.

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JULY 27, 2023 / 1:00PM, NOC.N - Q2 2023 Northrop Grumman Corp Earnings Call

C O R P O R A T E P A R T I C I P A N T S

David F. Keffer Northrop Grumman Corporation - Corporate VP & CFO

Kathy J. Warden Northrop Grumman Corporation - Chair, CEO & President

Todd B. Ernst Northrop Grumman Corporation - Corporate VP of IR

C O N F E R E N C E C A L L P A R T I C I P A N T S

David Egon Strauss Barclays Bank PLC, Research Division - Research Analyst

Douglas Stuart Harned Sanford C. Bernstein & Co., LLC., Research Division - SVP and Senior Analyst

George D. Shapiro Shapiro Research - CEO and Managing Partner

Jason Michael Gursky Citigroup Inc., Research Division - Research Analyst

Kristine Tan Liwag Morgan Stanley, Research Division - Equity Analyst

Matthew Carl Akers Wells Fargo Securities, LLC, Research Division - Senior Equity Analyst

Myles Alexander Walton Wolfe Research, LLC - MD & Senior Analyst

Peter J. Arment Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

Richard Tobie Safran Seaport Research Partners - Research Analyst

Robert Alan Stallard Vertical Research Partners, LLC - Partner

Robert Michael Spingarn Melius Research LLC - MD

Ronald Jay Epstein BofA Securities, Research Division - MD in Equity Research & Industry Analyst

Seth Michael Seifman JPMorgan Chase & Co, Research Division - Senior Equity Research Analyst

Sheila Karin Kahyaoglu Jefferies LLC, Research Division - Equity Analyst

P R E S E N T A T I O N

Operator

Good day, ladies and gentlemen, and welcome to Northrop Grumman's second quarter conference call. Today's call is being recorded. My name is Josh, and I will be your operator today. (Operator Instructions).

I would now like to turn the call over to your host, Mr. Todd Ernst, Vice President, Investor Relations. Mr. Ernst, please proceed.

Todd B. Ernst - Northrop Grumman Corporation - Corporate VP of IR

Thanks, Josh, and good morning, and welcome to Northrop Grumman's Second Quarter 2023 Conference Call. We will refer to a PowerPoint presentation that is posted to the IR website on the call this morning.

Before we get started, matters discussed on today's call, including guidance and outlooks for 2023 and beyond, reflect the company's judgment based on information available at the time of this call. They constitute forward-looking statements pursuant to safe harbor provisions of federal securities laws. Forward-looking statements involve risks and uncertainties, including those noted in today's press release and our SEC filings. These risks and uncertainties may cause actual company results to differ materially.

Today's call will include non-GAAP financial measures that are reconciled to our GAAP results in our earnings release.

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JULY 27, 2023 / 1:00PM, NOC.N - Q2 2023 Northrop Grumman Corp Earnings Call

And on today's call are Kathy Warden, our Chair, CEO and President; and Dave Keffer, our CFO.

At this time, I'd like to turn the call over to Kathy. Kathy?

Kathy J. Warden - Northrop Grumman Corporation - Chair, CEO & President

Thanks, Todd. Good morning, everyone, and thank you for joining us. As you saw from this morning's earnings release, global demand for Northrop Grumman's solutions is driving exceptional growth. In the second quarter, our sales were up 9% with solid contributions from each of our four business segments. Our ability to hire and retain talent and improving supplier deliveries are strengthening our top line. Given our year-to-date sales increase of 7% and an improved outlook, we're increasing our full year sales guidance range by $400 million. In addition, award volume in the quarter was robust, with a book-to-bill ratio of 1.14. As a result, we're increasing our full-yearbook-to-bill projection to approximately 1.0.

Our $79 billion backlog continues to be more than 2x our expected 2023 sales supporting our long-term growth outlook. We delivered solid second quarter earnings per share of $5.34, and we're increasing the lower end of our full year guidance range by $0.20. And free cash flow was healthy in the quarter, more than $1 billion higher than Q2 of last year, positioning us well for our full year target.

Turning to the budget environment and starting with the U.S. We're encouraged by the continued bipartisan support for national security funding to implement the Administration's National Defense strategy. The FY '24 budget and recent congressional committee bills prioritize modernization, including areas of strength in our portfolio such as the Triad, the Space domain, information superiority and advanced weapons. We also anticipate continued support for Ukraine and related emergency spending, which would represent even further increased demand.

Global demand for our products also continues to grow as our allies increase defense spending to address evolving threats. We are well positioned in multiple markets to meet this demand with programs such as AARGM, IBCS and E-2D as well as munitions. With a robust backlog and a leading growth outlook, I'd like to now spend a few minutes outlining our path to margin expansion, which is a key element of our earnings and cash flow growth plans.

Our 2023 operating margin dollar guidance is in the range we've previously provided. This guidance implies a segment margin rate in the mid-11% range in the second half of 2023, having delivered a rate of 10.9% in the first half. We also see an opportunity to increase our year-over-year margin rate in 2024 and get to a 12% target in the longer term. Achieving this margin improvement is built on three key drivers: First is the stabilization of temporal macroeconomic factors that have driven higher costs and impacted our supply chain and labor efficiency. Second is the ongoing implementation of cost management programs across the company that help drive affordability, competitiveness and performance. And third is our business mix, which we see shifting to more international and production contracts as international demand grows and many of our current development programs mature over the next several years.

With regard to the macroeconomic factors, supply chain disruptions rooted in the pandemic and the subsequent labor market tightness have created program delays and cost growth. To reduce this disruption, we're buying ahead of schedule, pursuing second sources where it makes sense, and placing more of our people at suppliers to facilitate timely material deliveries. We see signs of progress across our supply chain from these actions, and we are seeing fewer new issues emerge.

We've had exceptional performance in growing our headcount since the second half of 2022 and attrition rates are down to pre-pandemic levels. Our focus now is on optimizing labor efficiency, which is an important driver of profitability. To accelerate the learning curve for our employees, we're leaning forward with innovative training programs and standardizing work instructions.

Inflation has been a challenge for our industry as well as others.

Cost growth has now begun to moderate, but the last 18 months of inflation continue to have a higher base effect on our costs, especially in labor. If you look at our year-end 2021 fixed-price backlog, it was largely priced before we began to experience elevated levels of inflation. However, of that backlog, approximately 70% will have been converted into sales by the end of this year. And for new bids, we are factoring higher inflation

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JULY 27, 2023 / 1:00PM, NOC.N - Q2 2023 Northrop Grumman Corp Earnings Call

expectations into our contracts. We're also working to drive additional discipline in our bid approaches, particularly on fixed-price contracts to help protect against these types of dynamics in the future.

Overall, we anticipate that these macroeconomic impacts have stabilized and now have largely been incorporated into our margins or risk factors.

The second key driver of margin opportunity is cost management, which benefits both affordability and competitiveness. We are laser focused on overhead cost reductions. A foundational element of these reductions is our implementation of digital solutions across our business, which will help to drive performance and productivity. For example, we've built a digital ecosystem that focuses on program execution, bringing together employees, customers and partners into an integrated environment so they can seamlessly work together. This accelerates design, integration, testing and deployment across programs, helping us to deliver with quality, speed and efficiency. We're increasing the number of programs that are operating in this ecosystem, and today, we have over 100 active programs that are doing so.

We're also investing in and advancing the technologies and digital systems in our factories. We're scaling this across the enterprise to drive efficiencies that should benefit all of our stakeholders. For example, on the B-21, we've successfully demonstrated the use of this digital thread tied to advanced manufacturing technologies to realize over 15% labor efficiencies in one area of the build. And in June, we launched the expansion of this approach across the whole build process. We're extending this digital thread into our business operations to deliver further benefits across the company. This includes how we're managing our supply chain, where we've broadly centralized procurement and we're working to leverage our purchasing power to reduce costs.

We have over 20,000 suppliers, and we've begun securely connecting them into our digital ecosystem. Over the next several years, we expect to have the majority of our supply base fully integrated. This is expected to lower supplier costs and significantly improve productivity.

The third key area of margin opportunity is our business mix. For several years, we've had one of the highest cost-plus development contract mixes in the industry, reflecting our significant early-stage position on key franchise programs, which will transition to production throughout this decade. This cost-plus mix has been increasing, with our first half revenue at 55% cost-plus, up from about 50-50 last year. Looking forward, we see this shifting towards more fixed-price revenue, rising to approximately 60% of sales by 2027 as a number of large programs in all four of our sectors transition to production.

Production program margins are typically a few points higher than development margins, so mix shift can contribute meaningfully to our segment operating margin rate. And we are making good progress on moving programs through development and into production. For example, AARGM-ER completed its fifth consecutive test flight in the second quarter. This program is nearing completion of its development phase and is on track to ramp production volumes next year. And on B-21, we successfully powered on the first flight test aircraft in the quarter, another important milestone in our campaign to achieve first flight and transition to production.

We also expect our international business to grow at a double-digit rate over the next few years, improving our margin opportunity as global sales become a larger percentage of our mix. In the second quarter, we demonstrated our IBCS solution for eight potential international customers, reflecting growing demand for this advanced air and missile defense capability. We also signed a memorandum of agreement with Rheinmetall to expand capacity for F-35 center fuselage production in Europe.

We expect these three drivers to result in improved affordability, even better performance and higher margins. When combined with the strength of our backlog and increasing global demand, these operating margin improvements should provide the foundation for strong future free cash flow growth.

Now with respect to capital deployment, we're executing a strategy that prioritizes investments to support our business plans and returns cash to shareholders. In May, we increased our dividend for the 20th consecutive year by 8%. Year-to-date, we have returned $1.5 billion to shareholders and are on track to meet our goal of returning more than 100% of free cash flow this year. Overall, the global defense budget outlook and our alignment with customer priorities give us confidence in our growth trajectory. We are focused on margin expansion opportunities and converting this to free cash flow growth to deliver value both for our customers and our shareholders.

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JULY 27, 2023 / 1:00PM, NOC.N - Q2 2023 Northrop Grumman Corp Earnings Call

So with that, I'll hand it over to Dave, and he'll cover details of the second quarter financial results and updates to our full year outlook.

David F. Keffer - Northrop Grumman Corporation - Corporate VP & CFO

Thanks, Kathy, and good morning, everyone. We're pleased to report another solid quarter. We remain focused on executing our strategy and believe we're well positioned to grow our top line, earnings and cash flows for years to come. The demand environment continues to be robust, supported by the alignment of our portfolio with our customers' highest priority missions. And as Kathy described, we see a path to expand margins in the second half of this year and beyond as macro pressures ease and we drive efficiencies into our business as it grows and experiences mixed tailwinds.

Now turning to Q2 results. we generated $10.9 billion of new awards, a higher total than we previously expected. Our book-to-bill was 1.14 and was driven by restricted awards of $5.4 billion. This brings our year-to-date total to $8.6 billion in restricted bookings. Looking forward, we expect a number of production awards in the second half of the year, including the first lot of B-21 LRIP.

Moving to sales on Slide four in our earnings deck, we delivered strong top line growth of 9% in the second quarter, building on the momentum from Q1. As a result of our success in bringing on new employees, incremental improvements in the supply chain and continued backlog strength, our sales are growing at a higher rate, and we've increased our full-year guidance. With respect to segment results, all four of our businesses grew in the second quarter. Space continues to lead the way with their second consecutive quarter of 17% sales growth as GBSD, NGI and restricted space programs continue to ramp. And Defense Systems sales increased 10% on the strength of their armaments and missile defense franchises. Mission Systems growth of 5% was driven by restricted programs in the Network Information Solutions business, and Aeronautics Systems returned to growth as higher volume on restricted programs outpaced the headwinds on legacy programs as we've anticipated.

Turning to Slide five. Segment margins in the second quarter were 11%. Keep in mind that Q2 of last year included over $70 million, or 80 basis points, of benefit from a land sale and a contract-related legal matter. Most importantly, margin dollars improved incrementally from Q1, largely meeting our expectations. Program performance remains strong across the portfolio, as the team does a good job in navigating the lingering disruption from the pandemic and macroeconomic factors we've been discussing. One area of pressure we experienced in the quarter was a $36 million unfavorable adjustment on NASA's Habitation and Logistics Outpost program, or HALO, in our Space Systems sector.

Moving to earnings per share on Slide six. Diluted EPS in the second quarter were $5.34. This included lower net pension income of roughly $1 per share, partially offset by more favorable returns on marketable securities than in the same period last year.

Slide seven highlights the non-operational pension headwinds we experienced in Q2. On a year-over-year basis, 2023 pension income will be lower for all periods when compared to 2022, but these headwinds are expected to dissipate as we look to 2024. With respect to cash, we generated strong free cash flow in the second quarter of over $600 million, a significant increase compared to the same period last year, in which we had an outflow of $460 million. This improvement was driven by increased billings and timing of collections across the company. We paid roughly $360 million of cash taxes associated with Section 174, and we continue to expect a full-year impact of a little over $700 million.

Moving to 2023 guidance. I'll start with a few updates to our sector estimates, which you can see on Slide eight. Our Space business continues to deliver outstanding sales growth and bookings, demonstrating the strength of its diverse portfolio of capabilities. As a result, we're increasing sales guidance for Space to the high $13 billion range. Remember, as recently as 2019, this business was generating revenue in the mid-$7 billion range. So our guidance this year reflects a fantastic 4-year CAGR of roughly 17%. At Defense Systems, based on the strength of their year-to-date results, we're increasing our full year expectations for this business to the mid- to high $5 billion range. This represents growth in the low single-digit range. There are no changes to our revenue expectations at AS or MS. With respect to margin rates, we're maintaining our expectations for AS, DS and MS, and we're projecting a lower operating margin rate at Space to reflect the rapid increase in new program wins and their first half results.

At the company level, this translates to an increase to our sales guidance of $400 million and a growth rate between 5% and 6% for the full year. We're maintaining our expectations for segment operating income dollars. We expect a slightly higher full year tax rate of 17%, and we've reduced our projection for shares outstanding to the mid 152 million to reflect our latest share repurchase expectations. Our EPS outlook continues to

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