Northrop Grumman Corporation (NOC) Morgan Stanley’s 12th Annual Laguna Conference (Transcript)

Northrop Grumman Corporation (NYSE:NOC) Morgan Stanley’s 12th Annual Laguna Conference September 12, 2024 12:20 PM ET Company Participants Kathy Warden – President & CEO Conference Call Participants Kristine Liwag – Morgan Stanley Kristine Liwag I’m Kristine Liwag, Morgan Stanley’s aerospace and defense analyst. Thank you for joining our next session with Northrop Grumman with Kathy Warden, Chair, CEO, and President. Thank you, Kathy, for joining us today. Kathy Warden Thank you, Kristine. It’s great to be back with you. Kristine Liwag Great. And before we start, of course, always disclosures. I’ll have some to read and Kathy also. So for important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative. And passing it on to you, Kathy. Kathy Warden Yes, and good morning. I will likely make forward-looking statements this morning and those statements have certain risks and uncertainties. For a full disclosure of those risks and uncertainties, please refer to our SEC filings, which you can find at the Northrop Grumman website. And just to make a few opening comments, Kristine, before I turn to you for Q&A, our strategy at Northrop has remained constant to sustainably and profitably grow our business, and our financial results this year reflect a continuation of that strategy. We have seen in the first half of the year high single-digit growth in our top-line. We are projecting 5% growth at the midpoint of our guide this year. And we have had 5% annual growth for each of the last five years since 2019. Our backlog is up to $83 billion, which is a 30% increase since 2019, and we are projecting continued expansion of our margin rates with our EPS growing faster than top-line with a combination of that margin expansion and our share count reduction. I also think one of the most important things about Northrop’s trajectory is our free cash flow growth. We are projecting greater than 15% compound annual growth in our free-cash flow-through 2026, and expect that trend to continue. And we are very much positioned to deploy that capital effectively. We had a 10% increase in our dividend this year, and that is our average increase over the last 10 years. We also are on-track to repurchase 2.5 billion shares this year and 2.5 billion in shares this year and we as a result continue to see our free-cash flow per share grow even faster. So with that, we are looking at normalizing the investment in the business that has supported and generated this growth, bringing our CapEx to more normalized levels going-forward, but continuing to invest in our business because we continue to see a robust set of growth opportunities ahead both in the US and internationally. So with that backdrop, Kristine, I know you have some specific questions, and I’ll go-ahead and turn it over to you. Question-and-Answer Session Q – Kristine Liwag Well, thank you, Kathy. Maybe starting off with the budget environment. When we’re looking at the Fiscal Year 2025 defense budget, it looks like we’ll start again in another continuing resolution. And Fiscal Year 2025 is still subject to budget caps. But there seems to be appetite in Washington to change this number, maybe some upward pressure, but it is an election year. So you’ve got these multiple variables at play. How do you think this plays out? And how should we think about the moving pieces impacting your businesses and your programs? Kathy Warden Well, you are right. We do expect a continuing resolution again this year. It is not a situation that any of us like, but it is a situation that the industry has become accustomed to. We do expect that there will be continued bipartisan support for defense spending above the President’s budget requests. The SASC has increased above the budget request, and we see the SACd having passed a defense bill that also is above the President’s budget. So to your point, some upward pressure on what those defense budgets will look like in 2025, and we think that will continue. And it’s really driven by the threat environment that the Department of Defense is grappling with, as well as inflation, which is putting pressure on the real expenditure requirements for the Defense Department just to execute the strategy that they outlined. So we do see bipartisan support and discussion even as deficits increase to have a healthy defense budget that supports the advancement of US capability and continues to support our allies, which largely have been supported through supplementals, but some of that coming into the base budget as well. Kristine Liwag Great. And moving outside the US, when we look at international opportunities, we’re seeing other countries actually have more of an accelerated budget growth than maybe the US. You’ve highlighted before that international could grow faster than domestic. Can you give us any insight in terms of key programs to watch? How did this play out for 2025? And also what’s the margin profile of international sales versus domestic? Kathy Warden Yes. So our profile for international sales has been in the 12% to 15% range for a number of years and it’s largely predicated on the portfolio that we have that is well-aligned to US programs, but not as many exportable product lines as some of our peers. That has begun to change in the last several years, as we have put a focus on growing our international portfolio. We have about three times the number of programs today than we did when I took over as CEO six years ago, that we can now export and to more countries that we can export them to. Categories of products that are included in that list are our international air and missile defense programs, which we have now are fielding for the US Army and fielding for Poland. We have over 10 countries who have expressed interest in that capability. Also, tactical weapons. We have the AARGM-ER program that is getting qualified for F-18, F-35, and expect it to eventually be qualified for the F-16. There are many international countries who are buying those platforms and AARGM-ER is an affordable weapon to go on them. So we have a number of countries with letters of request for that capability as well. None of that was in our pipeline even just a few years ago. So it represents new opportunity for us for international sales, on top of what has been in our pipeline, sensors for those platforms that I just talked about through our Mission Systems business, aircraft programs like the Triton, which is being deployed in multiple countries and we are in the sales process with several more. And then the E-2D as well. Kristine Liwag Great. Kathy, I think from conversations with investors, I mean, no surprise B-21 and Sentinel had been dominating the conversation probably the past few years. So I think there was a little bit of investor surprise that actually collectively Sentinel and B-21 are only about 15% of your sales. Then you look at the collective exposure with F-35, that’s another 10%. You’ve got another 75% of your portfolio. Can you talk about, what you’re seeing in that 75%, how resilient is it? And what are key differentiators or are there other key programs you want to highlight regarding opportunities or risks in that 75%? Kathy Warden Yes. And thank you for picking up on that information that we highlighted in our second quarter earnings call because it really is important in many ways that diversity is the resilience in our portfolio. We are not beholden to any given program. And while the three programs you noted, B-21, Sentinel and F-35 are very important to us and to the nation, we have 75% of our portfolio that is supporting highly prioritized missions, whether that be the buildup and modernization of space across every dimension, communications, surveillance, missile warning and tracking, or it be in the weapons portfolio that I spoke about where we are supporting advanced weapons development with the US, but also supporting munitions for countries in Europe and particularly supporting the conflict in Ukraine. And then, of course, we also have a robust microelectronics capability in our company. We actually build microchips. Some of you may not know, we hold the Guinness World Record for the fastest micro trip, a trillion cycles per second. So and — we have microchips that are 1000 times more powerful than what you have in your smartphone. So these are obviously bespoke for applications specific to national security, but it gives you an indication of that expertise that resides inside of our company and ends up in everything from communications devices to radars to electronic warfare sensors that we build in our Mission Systems portfolio. It’s hundreds of programs, but it is some of the most technologically advanced and differentiated capability in our company and in the world frankly. Kristine Liwag I can’t even imagine what a trillion cycles per second what that actually means. Kathy Warden Yes, it’s a lot of material science that goes into building those and we have that kind of expertise within our company. Kristine Liwag That’s great. And you know, Kathy, in the last quarter you talked a lot about the B-21. You provided more details on the not to exceed contract, which is really helpful. Can you talk about the overall trajectory of margins for the program? What are the key risks and opportunities here for the B-21? And I think it alleviated a lot of investor concerns to know that the next lot would be profitable. Any more context would be helpful. Kathy Warden Yes. So we have outlined that the B-21 has four major components in the program. The first is the development program that we have been executing upon since award. And we’ll continue to finish out that development work for largely the remainder of this decade, but it will become a smaller portion of the program. It is profitable, but it’s less profitable than our typical development program. The second part of the program is what has attracted a lot of attention, and that’s our low-rate initial production, which was priced back in 2015 when we were selected. And with that fixed price we through inflation have experienced cost growth. I want to emphasize the performance on the program has been exceptional and been highlighted by the government as a model program. And we expect that strong performance to continue, which is why we have confidence that the charge that we’ve taken on the LRIP portion of the program, representing all of those price lots, which is the first five lots is a good representation of what it will take to complete those lots. Then we have a series of units that have not to exceed pricing. That pricing is above the LRIP pricing. It also includes economic price adjustment clause. So we expect that will be profitable, and then we move into full rate production, and we expect that to be even more profitable as is the normal trajectory that you see on production programs we continue to gain in productivity and learning curve and we negotiate those full rate production lots. We begin the NTE units in 2026. We complete the LRIP units largely this decade. And that gives you a sense of the timeline for those various elements of the production phase. And then finally, we have the modernization and sustainment. Think of this as new development work in the modernization area and sustaining the units as they’re deployed. This is expected to be accretive to the overall program margins and to grow over time, starting now. Kristine Liwag Great. Thank you for the color and maybe shifting to the other development programs. We’ve seen the next generation air dominance program, NGAD and F/A-XX all moving to the right. As you know, the government figure out priorities and requirements. You were very clear that you don’t intend to bid on the NGAD as a prime. Can you update us on your strategy and how you’re thinking about this — the opportunities in these next generation programs and where Northrop fits? Kathy Warden Yes. So both the Air Force and Navy have disclosed that they are pursuing proposals from industry on their next generation fighter since we last spoke. And we did clarify that we had not submitted a prime proposal for the Air Force program, but we are actively engaged as a supplier, particularly in the mission systems area. The Air Force has taken a strategic pause on that program and are revalidating requirements and the path forward for it. If they determine that there will be a material change to the program, we would go back and reevaluate just as we would any new opportunity whether we think that it is a program that we’re well differentiated to perform, whether we view the business case as one that makes sense for our company and our investors, and we would look at new alternatives. So we’re monitoring that one. In the case of the Navy, they continue to be committed to pressing forward. They have proposals in. It’s clarified that we are one of the three bidders on that program. And so we are still expecting an award next year from the Navy on their program. And we believe that we’re well qualified. We have not only the capabilities in 6th generation technologies like stealth and survivability, but we also have experience as major supplier on fighters and a leading prime on 6th generation aircraft with the B-21. So we will continue to monitor that space and look to capture our fair share. Kristine Liwag Thank you, Kathy. And no surprise, a Sentinel question. Kathy Warden Yes. Kristine Liwag So Sentinel, how are things going with the restructure of the program? You are very clear that look, the Nunn-McCurdy portion is in a production phase, it’s the infrastructure phase, it’s not your technology. But — and that really — the Nunn-McCurdy is really like the 2030s timeframe. Can you give us any context of even though it’s not really on your portion of the program, how does it affect your near-term earnings possibility and revenue for Sentinel and how does that shape? Kathy Warden So a little bit of context on Sentinel and the Nunn-McCurdy assessment. It was driven by the program going through a cost estimate update, which happens regularly on programs after a few years pass. And this — the last one for Sentinel had been done in 2020 prior to the effects of the pandemic. So when those cost estimates were updated in 2024, early 2024, it triggered what is called the Nunn-McCurdy breach because of the growth in the cost estimates. And to your point, it’s largely looking at the next phase of the program, which is when we will do construction in the missile silos to build the launch facilities that the missiles go into that drove the cost increase. I think we’re all aware that inflation on construction ballooned during the pandemic. And as those estimates then were flowed through the program, it was a sizable increase. We are working with the Air Force on some modifications that they could choose to make that would further reduce the cost of the program. And that’s what’s happening in this restructure phase that the government has talked about, and they believe that’s going to take 18 months to 24 months. In the meantime, we are moving full speed ahead. The program is staffed, we are executing under the program, and the missile is moving along quite well, as are all those test and support equipment. The restructure is really focused on driving important decisions from the government that will affect the design on the construction scope of the program in the next phase. But the design work is well underway. Kristine Liwag Thank you, Kathy. And shifting gears to defense systems, I mean, defense systems went through a period of flat sales. Now you’re seeing a nice acceleration. Part of it is with Sentinel, but also the rest of the portfolio seems to be growing nicely. Could this segment be your fastest-growing segment in 2025? And also, especially with all the demand with missiles and munitions, can you give us some context around this? Kathy Warden Yes. So as our — as you talked about our defense business, as it was positioned prior to us realigning Sentinel into it had gone through a few years of compression. We had sold a part of the business. We were exiting some elements and doing that through contract, and we have seen those pressures and headwinds on the business. Last year the business grew about 5%. This year, we are on track to grow that business. Prior to Sentinel moving in, we were guiding in the high single digits. And now with Sentinel moving in, it’s just solidified that to the upper end of that range. So as we look forward, we expect those trends to continue in defense. Sentinel will be a contributor to growth, the weapons expansion will continue to be a contributor to their growth. And international is a cross-company set of initiatives and pipeline, but it mostly impacts our defense systems business in a positive way. We also believe those trends are margin accretive. So while you focus the question on top line, we expect it not only to be one of fastest growers but to be a more significant contributor to our margin expansion. Kristine Liwag Great. And on the space segment, which had been your previously fastest growing portfolio, you had Sentinel NGi restricted all in there, and now you’re taking a bit of a pause on growth, but that seems to be returning in 2026. Can you talk about the movers and shakers of that driver since these programs are not in that segment anymore? Kathy Warden Yes, that’s an important point, because if you strip out NGi and Sentinel, the business was still growing very nicely and it was about half and half. The contribution of our space business growth last year was half of it was Sentinel and NGi, and the other half was the rest of the portfolio. So around 5% growth is what you could think of for that non-Sentinel NGi business. Of course, we’ve moved Sentinel to the other part of the portfolio and just talked about that, NGi that loss and the termination of a restricted program accounted for about a billion and a half of sales. Half that headwind will absorb this year in a year-over-year. Compare the other half next. But that underlying business that was growing at mid-single digits, despite the fact that space budgets have flattened for the Department of Defense, we still have our space business growing and expect that to continue minus those two impacts. And so once those have flowed through the system, we fully expect that the space business will return to growth on the strength of the rest of the portfolio. Kristine Liwag Great, maybe shifting gears now to margins, right? You’ve talked about margin expansion in 2025, you’ve got a 12% long term margin target. It seems like this is driven by partly the macro environment, efficiency initiatives, a shift from more fixed price development work to international work, which is more attractive on margin. How should we think about this trajectory and which segments or programs provide the most opportunity for margin expansion? Kathy Warden We really see all of our segments having opportunity for margin expansion. It’s a matter of timing as to which will contribute more in the near term versus the ones that will contribute more in the longer term. So in the near term, we’ve talked about the dynamics in defense systems with all of the elements we just focused on the portfolio, the large portion of fixed price work in that portfolio, the increase in international, which is a tailwind to margin rate, all should contribute to defense systems being a near term margin expansion opportunity. Mission Systems has most recently been impacted by the macroeconomics that we’ve talked about and some of the productivity challenges of scaling that business. So we also expect in the near term off of this lower base, they will accelerate margins more rapidly in the next couple of years. On the end, space really has already started to see that shift. Their margin enhancement over the last two quarters we’re very pleased with and expect to see that trend continue. They’re largely driven by performance and just continued enhancements in cost efficiencies and driving harmonization in that business. For AF the opportunity is a bit more backloaded in our five-year plan, in that the new business there is largely dilutive to margin. We have other more mature programs that are more than half of that business contributing very strongly to margins, and they have held strong. I’m really proud of how that team is performing, but they will really not grow out of this and have margin expansion until we get further along in the B-21 program, as we described earlier. So we expect their margin contribution to that 12% to come more toward the later part of our plan. Kristine Liwag Great. Thanks, Kathy. Now, Mission Systems. I mean, Mission Systems historically had been a strong performer both revenue and margin, but lately, it’s been a little bit under pressure. Can you talk about what actions you’re taking to improve operations, and can we get back to 15% margin when and is it possible? Kathy Warden So what has dampened the Mission Systems’ margins are really three things. Two, I’ve already touched on. We have a lot of microelectronic suppliers in that supply chain, and the disruption related to the pandemic loss of learning and productivity challenges that our suppliers had have disrupted our factories. We are normalizing our way out of that and expect that to continue into next year. And we do expect to see improvements next year. We also have a mix shift that has occurred in that business. We have much more development work today than our historical average there. And what that has meant is development programs typically are lower margin rate than production, so we just have more of it. The good news is that sets that business up for nice backlog growth and visibility into where growth will come from for the next several years, as those programs move from development to fixed price, we would expect that to be a natural tailwind to margins. And then the third is we are working cost efficiencies in that business just as we are in all of our business, and we are upgrading our factories. That upgrade of factories can often have some interruption to productivity in the near term as we grow scale but also implement new processes, but in the long run are meant to drive us to higher levels of productivity and therefore higher margin rates. So all those dynamics are going on within Mission Systems right now, setting the business up for longer term success. And definitely, we see that they can get back to those margin rates that we are accustomed to for their business because all of these things are fairly temporal and we can point our finger to what’s driving it. Kristine Liwag Thank you for all the color there. Now on free cash flow. Your free cash flow outlook leads industry. Can you talk about the drivers of how you’re going to accomplish that? Kathy Warden Yes, really, it’s four simple things, hard to execute, but easy to outline. First of all, continued top line growth that we’ve talked about already, the margin expansion that we’ve just outlined, and then the two pieces that we haven’t talked about as much are normalizing our investment. Our CapEx today is higher than our normal levels of investment. We’ve done that purposefully to drive the growth that I’ve just outlined and to really invest in our business to be able to handle the capacity increase that we know our customers need to support their long term missions. But we will normalize that over time. We’ve talked about even in the near term getting back toward 3% of sales invested in capital. And then the other is cash taxes coming down. We’ve talked a lot about Section 174 and the contribution there to higher taxes and that that will normalize over the next couple of years as well. So those are the key ingredients. And greater than 15% compound annual growth through 2026, we do believe is market leading. And we continue to be very focused on our efficient use of cash and very pleased with how the team performs in that regard as well. Kristine Liwag Thanks, Kathy. And now with all this cash you’re generating, we now expect $2.5 billion of share repurchase this year. You’ve talked about a 10% increase in dividend. Can you give us an update regarding capital deployment priorities, especially as you generate this cash? And when we look at the debt maturity in January, how do you expect to resolve that? And from there, what happens? Would you be willing to lever up the balance sheet and deploy more capital to return to shareholders, any target leverage would be a helpful context? Kathy Warden Yes. Well, we’re happy with our current leverage and our credit ratings at BBB Plus, so there’s no real focus on needing to move that needle. What we think about is we first want to invest in our business where we see smart growth opportunities. And so we have been doing that. We’ve talked about more normalization there, which leaves us more excess cash. We have a dividend policy that we adhere to pretty closely. It has allowed us to increase the dividend as I said on average 10% a year for 10 years, which we think is a really good track record and would signal to you that we continue to be committed to paying a competitive dividend. And looking at where we sit within our target payout ratio, we have room to continue to move in that regard. We also use share repurchase as a tool to return excess cash to shareholders. But we really think of it in that prioritization that I just outlined. And we like having the optionality that we have with a view into free cash flow growth that’s supported by a portfolio that gives us good visibility with some of these very long-term, stable programs that we will continue to have that optionality well into the future. Kristine Liwag Great. With the time we have left, we probably have time for one more question. Kathy, when you look at the next year, maybe next 12 months to 18 months, what are the key priorities? What keeps you excited? And then the question I also have that I’m scared to ask is like what keeps you up at night? Because of all the things that, you know, that that’s probably what keeps you up at night should probably keep all of us up at night. Kathy Warden So the two questions are really highly related that what got me into this industry is a focus on making our world a safer place for everyone in the world to feel safe and secure in their homeland. And I came into the industry following 9/11 because it was the first time in my lifetime and by the way, I just had my first child that I contemplated whether we were safe in our homeland. And then I recognized there are people all over the world that feel that way on a more constant basis. And so I came into this industry thinking that I would do good work and contribute to global security for a period of time and then go back to commercial technology, which is what I had focused on up until that point in my career. And I thought that excited me. I thought technology was my passion. But what I came to realize is making a difference in the world is so much more important. And from this vantage point, I get to feel like I’m doing that, even in a small way. So it’s both what excites me and gets me coming in and charged every day, but it’s also what keeps me up at night, because we need to continue, not take for granted that democracy will be supported around the globe and that the freedoms we so enjoy and often do take for granted are going to be there if we don’t do the things that we’re doing to project power and deter others from coming after our way of life. So that’s what I focus on. That’s what I do. But within the company, bringing that to reality means that we have to stay on the leading edge of technology advancement, both as a company so that we can support the countries that we enable with those technologies. And I believe that our company has a differentiated capability in that regard. And then turning that value engine into profitable growth and expanding our ability to have mission impact through generating strong returns, reinvesting that, it helps our shareholders, but it helps our customers as well, and it reaches that ultimate goal of making the US and our allies stronger. Kristine Liwag Wonderful. Well, Kathy, thank you very much for all the hard work you do, and I do feel safer knowing that you’re part of the solution. With that, this concludes our presentation with Northrop Grumman. Thank you, Kathy, for coming. Kathy Warden Thanks, Kristine. Thank you all for joining us.

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