Northrop Grumman Corporation (NOC) CEO Kathy Warden Presents at Bernstein's Virtual Strategic Decisions Conference (Transcript)

Northrop Grumman Corporation (NYSE:NOC) Bernstein’s Virtual Strategic Decisions Conference May 27, 2020 9:00 AM ET

Company Participants

Kathy Warden - Chairman, President and Chief Executive Officer

David Keffer - Corporate Vice President and Chief Financial Officer

Conference Call Participants

Douglas Harned - Sanford C. Bernstein & Company

Douglas Harned

[Call Starts Abruptly] …and if I were to set GST aside for the moment and think of the space. It is difficult, I know because so much of what you are doing in your space is classified. Is there a way for us to think about how you are playing this area with respect to satellites in launch? I know the budget for that area, they are growing quite rapidly. And we have gotten a good backlog increase. I mean, how can we on the outside get a sense of the kind of growth we should expect there?

Kathy Warden

So in terms of classified space, it is difficult for us to talk about what is in that collection of program. So what I can say is we are seeing a recapitalization of almost every missionary in space.

As these assets need to be more survivable and more capable given the role space will play in the future surveillance and war fighting domain. We are seeing that areas where we have traditionally had a presence are being renewed and modernized. And then areas where we have not been a prime integrator, and we are having the opportunity to compete and enter those parts of the market.

And that is what is driving our anticipated growth in space. That is what is driving the awards that we spoke about earlier this year. And so just think about it as missions that we understand well, that we have been participating in, and one of three things is happening.

We are getting new work on existing franchises. We are getting the opportunity to step up and do more work, because now we have an expanded portfolio with the addition of Orbital ATK or we are competing in new adjacent parts of that market and it is across all of dimensions that we see growth in our classified space.

Douglas Harned

And in the Orbital ATK integration that is, I mean that, I mean our sense has always been one of the most important reasons for doing that acquisition. First place was a participation in space and in the areas you are talking about. But now you are doing the integration, you have done a new organization, you developed a new organization, which we would assume will play even more into the synergies you can get out of that merger.

Can you talk about from here? I mean, as we expect to see more cost synergies. I know you have gotten a lot of them already that exceeded your original target. But so we expect the next level now that you put these organizations together and what I would say is a more logical way given the businesses that they are in?

Kathy Warden

Well, we absolutely are focused on continuing to harvest cost synergies. As we have now done the restructuring. As you noted, we had set an original target of $150 million for cost synergies at the start of this calendar year. We did meet that target, but we didn’t stop identifying ways to drive efficiency across the portfolio.

And it was just in January of this year, that we started operating in the new structure. So we clearly are finding additional cost synergies as we bring that business together. But the real reason for realigning the portfolio and bringing our space assets together was to realize the revenue synergy that we anticipate.

By now having all of our space team working together, engaging with customers to finding solutions, and able to use the whole of the team’s abilities to execute our work. We believe that that will lead to more program awards, and improved performance on those programs all of which will contribute to the growth and margin performance of the business overtime.

Douglas Harned

Well, as you described a lot of this. I mean clearly means your focus is on technology winning new development programs that build positions for the future. But when you get more development work, typically you are seeing work come in on cost on a cost plus basis may have some risks as well through the development phase. How should we think about the evolution of margins here given the nature of your portfolio?

Kathy Warden

We clearly are going to see some margin rate pressure as we continue to build the development portion of our portfolio. And yet, I noticed we are taking them through way costs structure changes.

This realignment is helping us to identify more cost synergies across the business. And so we are looking to in some ways, counter that margin pressure that the portfolio is naturally experiencing as a result of bringing more early phase development work into the programs.

We also, as we think about the long-term are very focused on margin dollar expense term. And so this work while it is bringing those days, which creates opportunity for cost synergy across the portfolio, will overtime give us volume that translates into higher margin opportunity as these programs move into late stage development or production.

So it is clearly the right thing to do to bring this work into the portfolio even though in the near-term it is going to have some margin rate pressure issue alluded to.

Douglas Harned

And then a question came in here is on GDSC? And, I guess it is about you kind of answered it earlier on the timing for receiving the GDSC award. But also, I would add to this, whether you see some people have speculated that GDSC being very large long-term program, if there is budget pressure, or just potential that you get stressed out. Are you seeing any of this or that as a possibility that this could take a little bit longer to push through development perhaps you had thought.

Kathy Warden

We are actually seeing quite the opposite focus, a focus on schedule and the importance of getting through the engineering phase of this program on time, which is to achieve IOC in 2029. And the reason is our ICBMs are aging and they need to be replaced and in order to do that, we have to get through the Engineering, manufacturing and development stages of this contract.

And therefore, it is important that we both get started now, as the Air Force has indicated as their intense with an award later this summer. And then to stay on schedule to be able to reach that IOC targets in 2029 and begin the replacement of the system so that we have a fully capable third leg of the triad.

Douglas Harned

And on the other leg of the Triad you are working on, I have to ask the questions obviously impossible question. But can you tell us anything about how B-21 bomber is proceeding here?

Kathy Warden

Well, the Air Force is out and making public statements both about their pleasure with how the program is proceeding and also their intentions long-term for the bomber fleet, which is an indication that they have confidence that we will have a solid B-21 that is able to grow and expand as part of the bomber fleet as they had anticipated. So while I can’t say anything, I would simply point you to statements that the Air Force is making about their intentions for the program.

Douglas Harned

Okay, I know that is always a difficult one here. So F-35, a big program for you. Right now, we are heading to a point where it looks like we are going to end in kind of a steady state production rate within the next couple of years, so how do you think of F-35 as a growth program, when we go out farther the next three to five years?

Kathy Warden

So we think of our work on F-35 in three major areas. One we are involved in the production program, which is of course, the biggest portion of the program for us. And we are delivering systems ahead of Lockheed’s deliveries to their customers because we are building synergy philosophy and mission systems that need to be integrated into the aircraft.

And so we are about a year to 18-months ahead of the ramps that you hear on the program overall in terms of delivery cycle. There are two other important parts of the program though to keep in mind. One is the modernization effort.

And particularly for the mission systems, we are involved in modernizing those mission systems, which will include not only producing the new sensors that go on to the future production aircraft, but also retrofitting the existing to the extent that is planned for each of the mission systems.

And then the third is sustainment and that will be an increasingly important part of the program. We are both on performance basis logistic contracts, particularly for those sensors that we build. And then we also have work share with Lockheed Martin as the prime on the overall sustainment contract for the U.S. government and we have pursued international opportunities for sustainment as well.

So that piece of the program for us today is relatively small, but we expect we will grow overtime. So with these three pieces of the program, we see steady growth for the foreseeable future.

Douglas Harned

And I’m interested to understand a little more about on the sustainment side. How does this work with Lockheed Martin, Northrop Grumman, BA Systems do what is the approach to sharing the work on that on sustainment?

Kathy Warden

It is very much like the work share arrangements that we have on the aircraft itself. It is based on the expertise of each company and what we are able to contribute and those decisions in terms of exact work scope are made based on the needs of the program in any given time, and with Lockheed as the prime we take our direction through them, but we also are able to contribute.

Our expertise is clearly with the mission systems, and the support as I mentioned that we are providing through the performance based logistics, but on the aircraft itself, we also are providing quite a bit of support for the Navy variance of the platform.

Douglas Harned

Within airspace here, can you talk a little bit about unmanned systems and autonomous systems and how you see that rolling clearly the Hale systems has been your most important area there, but how should we think of this in the future growth on the Hale systems but then also have other areas that that can come into play here?

Kathy Warden

Well, certainly with unmanned, we have some programs that have been in existence now for almost two decades. We talk about unmanned as a new technology, but in the case of Global Hawk, those systems host and flying for a while and we do see the air force expressing some intend to phase out some of the global Hawk aircraft overtime.

Then we have Triton, which is just coming online and starting production. We reached our operational capability milestones and they are operating now out of Guam and providing great intelligence out in the Pacific. So we see different phases in the programs that we are operating for the U.S. but then we also see continued opportunity for expansion internationally.

We have a Triton going to Australia and we anticipate another award for more aircraft coming out of Australia this year. And of course we are delivering global Hawks to NATO, to Korea and to Japan. So we will continue to support those aircraft in the long run as well.

Douglas Harned

And when you think of that on the international side, on one hand we often look at an international program done necessarily north of grow-ins, but others as they can sometimes be episodic. In other words a country will buy a certain quantity and then you are done and you have to move on. With respect to Global Hawk and Triton how do you see that evolving in terms of can it grow more internationally? Can you get approvals - to extend the number of countries that you can get approvals for this to be sold to? How should we think about international growth terms?

Kathy Warden

Well, we are certainly looking at the ability to sell unmanned systems to more countries and it is governed largely under the missile control regime. And as we look at that set of requirements, we are constantly reminded that unmanned aircraft are in the international space quite new.

And as the technology becomes better understood, we do think there is opportunity for the export controls to become more limited, but still very potent in terms of what we are trying to control as a technology.

And so there is opportunity there. We aren’t necessarily counting on that as we look forward in the near term, we think that there are nations like Australia that will grow thereby overtime as these systems are put into operation and they understand the value of them, they create the maintenance infrastructure needed to support them and they are then able to just add quantity.

But it will be much like manned aircraft and to your point it will be a sale to each country and each country will grow that by overtime based on both their budgetary environments as well as the mission capability that the aircraft is able to demonstrate.

Douglas Harned

We do you see your growth in manned just being more driven by the U.S. or more driven -.

Kathy Warden

Certainly it is still more driven by the U.S. in that the U.S. budget is significant and we already now have an infrastructure in place for all of the services to operate autonomous systems and that is still being formulated in many of the international countries that I mentioned.

Douglas Harned

You did refer a little bit to missiles there. I know we have taught over time in the past Northrop Grumman’s desire to become a third missile supplier potentially in U.S you have certainly the AARGM contract. Can you talk about how you see the role that Northrop Grumman can play in that area?

Kathy Warden

We do and certainly we have been clear that in the right circumstances, we see the opportunity to be a prime system integrator, and AARGM-ER is a good example of that where we are the lead and we have integrated expertise from across our company on propulsion, on the navigation, on the composite structures to bring together what is needed to lead as a prime system integrator.

But there are plenty of opportunities still where we believe the right approach to market is through partnering, and we are doing that on a number of systems with other prime system integrators where we are bringing a piece, perhaps it is navigation, perhaps it is guidance and perhaps it is propulsion. But we are more than happy to bring those technologies through other primes when they are best positioned to integrate.

And we believe that is what, the competition that is healthy and the industrial base is all about that we are able to both choose to integrate our own capabilities and prime when we feel we are competitive, but work with other parties when we feel that technology is best in the hands of someone else to integrate and provide to the U.S. government.

Douglas Harned

You know, I know that. Certainly recently demand for vessels has been very, very high and certainly Lockheed Martin, Raytheon we are missing a lot of demand there. So, it does appear, it does set up to be a space that I would think, should be attractive. But if you think five years out, do you have confidence that, the kind of demand we are seeing today is still going to be there in five years to make it sensible to be investing in this area and playing along?

Kathy Warden

I certainly think over the long-term, the market is big enough for three providers of weapon systems, and I certainly believe that while maybe episodic in terms of the level of production that we see today, one, because budgets are healthy, two because we have been in conflict in the Middle East for a number of years and needed to replenish supplies.

And third, just being in a natural life cycle of having a number of mature weapons systems in production simultaneously have led to what we have seen for the last few years, that won’t sustain it. It hasn’t sustained in the weapon systems business.

But certainly when you look over the long-term, we believe that demand signal will be there and there will be new requirements that create the potential for companies like ours to enter in particular areas.

Again, AARGM-ER as an examples, but we also look at other future advanced weapons systems. We talked about hypersonics. We see that as part of this broader market space over the long-term, and we do believe that there will be enough demand signal to support three suppliers.

Douglas Harned

Well, going back to international. We talked about unmanned, but today I believe your international exposure is about 15% of revenues. And do you see that percentage increasing overtime and if so, in what areas other than unmanned should we expect you would be growing it?

Kathy Warden

So, we are at about 15% of sales outside of the U.S. as you noted, and we see that growing but modestly, and the reason is our portfolio is focused on high-end technologies, much of which is not exportable, and that is still very important to us. And you will see growth in areas like B-21 and GBSD overtime where there won’t be an export market. We can’t take what we are developing there to other customers.

And so domestic revenue will be growing at a nice clip as well, which means our international as a percent will be kept in check even if we are growing it. And that is what has been happening. We have been growing our international portfolio at about the same rate, maybe a little higher than our domestic portfolio in recent years.

And so overtime the kinds of products that you would see us sell internationally, certainly we believe weapons systems that we are building today will have the opportunity to go on global platforms. We also see our sensors business continuing to have a robust international opportunity sets that we have been building the radars for the modernization of that six teams around the globe and that continues to grow nicely.

But even ground-based radars, we see the opportunity for international sales there as well. And then as I noted with our unmanned portfolio growing outside the U.S., there is also a maintenance tale. So we see our defense systems business where we do our sustainment also having a nice growth trajectory outside the U.S.

Douglas Harned

Now why you did not mention there was E-2D. Can you talk about that potential?

Kathy Warden

Sure. So we do have international customer E-2D. We noted the Japan purchases and we have now a nice backlog for E-2D in Japan and we are also exploring other countries who might look at E-2D as an upgrade in their portfolio as well.

Douglas Harned

Okay. Does it do that in principle people have and E-2 today are natural customers I would assume so. One other thing in international, given the COVID-19 environment given even changes in oil prices, I mean, have you seen any changes in how your international customers are looking at their budgets and their ability to pay for some of your programs?

Kathy Warden

Well, we certainly are mindful of what is happening, particularly in the middle-East and the impacts not only to a payment on existing programs, but what the future holds for new sales in that area. We have quite limited exposure when you look at the amount of revenue outside of a few countries in the middle-East and even within the core countries where we do like the kingdom of Saudi Arabia, our revenue is quite small as a percentage of our overall international business. So we don’t see a tremendous amount of exposure there, but it is something that we certainly are monitoring as we engage in new contracts.

Douglas Harned

Now I want to turn it over to thinking about cash flow a little bit because certainly with GBSD and you have been looking at an elevated period of CapEx. Can you talk about how you see that trajectory going forward given all the development work that you have underway?

Kathy Warden

We can, and I’m actually going to turn to Dave so that he gets an opportunity to speak as well.

David Keffer

Sure, happy to do it. As we think about GBSD as we mentioned on the last few earnings calls, that number is let us do the $5 billion CapEx projection that we use this year, which is about the same level that we have told people to expect in 2021, before reducing overtime as a percentage of revenue.

So we continue to focus on investing in business particularly in areas that can be both drivers for the business like GBSD over the decade, - an important use of our cash. But it just number of new specifically we will talk about in terms of the - federal deployment approach. We continue to pay down debt, remember coming up over the next year or so and to continue on the path through the BBB plus credit rating. Continue to do the healthy dividend which we saw from the 10% increase -.

On the share repurchase side, we have repurchase $500 million earnings calls as we mentioned the changing our full-year target earlier in the year, and we continued for return to shareholders speaking part of our strategy. So right now our strategy - that we have healthy cash flows this year in projecting going forward.

Douglas Harned

I’m curious, because when you think of CapEx as it relates GBSD, that sort of one day program is kind of one big slug there. But it was certainly Northrop Grumman has, as we have discussed a large array of new development programs. Can you be pretty confident, I mean, in a way you could be a victim of your own success on this as you continue to win work and you have to invest alongside it. But can you give us a sense, you feel pretty confident that as you move through the GBSD and that sort of over the next couple of years that CapEx can come down. And then when we expect to see more cash deployed to shareholders and in that timeframe?

David Keffer

We will continue to assess those alternatives as you get the CapEx pointed out. To your point those are great problems to have where we have key programs today - a little CapEx investment opportunity for tremendous long-term growth and we are happy to make those tradeoffs overtime.

Each quarter each year as the set of alternatives ahead of us whether that be paying down debt further, to my earlier point, we think we can achieve that BBB plus rating and we can decelerate the rate of level we have or shareholder returns and moreover dividends and share repurchases, those who are in constant here.

We will also look at opportunities to pay into the pension programs and depend upon we have an issue where asset returns are, discount rates are as well as where legislation is in terms of retiring pension funding. So that will be the dynamic each quarter and each year, CapEx - that create more opportunity on the potentially other elements of that that traffic.

Douglas Harned

Well to wrap up in a way here. I wanted to ask about when we get through the pandemic, and we are on the other side of this, hopefully not too long. Other ways that you are thinking about the business differently. In other words, do you affect any change in your priorities as it relates to cost cutting, levels of investments once we move through the COVID-19 issues.

Kathy Warden

We have certainly found opportunity through the new environment that we are operating in and we are going to continue to mine those opportunities. And a few are in the cost reduction category. So we have been more focused on cost reduction this year as a result of COVID-19.

And we look at things like facilities on a long-term basis that we now envision not needing as much facility capacity given the changes that we are making in the way we are operating. We look at areas like travel and don’t expect to be traveling at the pace that we were anytime soon. So these are natural changes that will result from COVID-19.

But as I look more longer term, I would say that our commitment to investing in this portfolio, our commitment to creating technologies that are differentiating and that are providing our customers with the capability to counter very sophisticated adversaries that focus won’t change. We are as committed to that as we have been, if not more so.

I think what we have all observed in the last few months is that while the U.S. has been very focused as it should be on COVID-19 response, there are activities going on around the globe that reminds us every day about our adversaries intent and ability to continue to demonstrate a weapons capability that we need to be able to counter to protect the citizens of the U.S. and our allies around the globe. And we are absolutely committed to continue to do that and put the resources toward it that are both appropriate and necessary to create value.

Douglas Harned

Well, with that I think we will wrap it up here, but I wanted to thank you, Kathy and Dave very much for joining us. Hopefully next year we can deal with it physically, but this has been great. I also want to encourage everyone that is listening to complete the Procensus poll at the end here and you will get some immediate feedback. But, again, Kathy, Dave thank you and I look forward to talking soon.

David Keffer

Thanks.

Kathy Warden

Thanks Doug, stay well.

Douglas Harned

You too. Thanks.

Question-and-Answer Session

End of Q&A