Northrop Grumman Corporation (NYSE:NOC) Q2 2023 Earnings Call Transcript

Northrop Grumman Corporation (NYSE:NOC) Q2 2023 Earnings Call Transcript July 27, 2023

Northrop Grumman Corporation beats earnings expectations. Reported EPS is $6.06, expectations were $5.33.

Todd Ernst: Thanks, Josh. And good morning and welcome to Northrop Grumman 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. For 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 GAAP results in our earnings release.

And on today’s call are Kathy Warden, our Chair, CEO and President and David Keffer, our CFO. At this time, I’d like to turn the call over to Kathy, Kathy?

Kathy Warden: 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 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. Even our year-to-date sales increase of 7% and an improved outlook. We’re increasing our full year’s 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 year book-to-bill projection to approximately 1.0. Our $79 billion backlog continues to be more than two times 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 a billion dollar 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 bill 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 [Argonne] IBCS and E2-D as well as munitions. With a robust backlog and 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 plan. 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 macro economic factors that have driven higher cost and impacted our supply chain and labor efficiency. Second, is the ongoing implementation of cost management programs across the company that helps 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 macro economic factors, supply chain disruptions rooted in the pandemic, and the subsequent labor market tightness, have created programs 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 delivery. 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 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 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 macro economic impacts have stabilized and now have largely been incorporated into our margins 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 reduction. 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 high to advanced manufacturing technology 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 operation 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 house 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 margin. So mix shift can contribute meaningfully to our segment operating margin rates. And we’re making good progress on moving programs through development and into production. For example [Argonne 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 in 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.

Photo by NASA on Unsplash

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 plan 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. 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 Keffer: 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 topline 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 those 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 4 in our earnings deck, we’ve delivered strong topline 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.

In defense system 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 networked 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 5, 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 macro economic 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 outposts program or HALO in our space system sector. Moving to earnings per share on Slide 6, 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 7 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. We’ll start with a few updates to our sector estimates which you can see on Slide 8, our space business continues to deliver outstanding sales growth and bookings, demonstrating the strength of its diverse portfolio 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 Four year CAGR of roughly 17%.

At defense systems based on the strength of their year to 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 AS, DS and MS and we’re projecting a lower operating margin rate at space to reflect the rapid increase in new program winds and their first half results. At the company level, this translates to an increase to our sales guidance of $400 million in a growth rate between 4% 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 reduced our projection for shares outstanding to the mid $152 millions to reflect our latest share repurchase expectations.

Our EPS outlook continues to assume Q3 Closer of the sale of the minority investment for which we increased our full year EPS guidance by $0.40 last quarter. This quarter, we’re increasing the lower end of our guidance range by $0.20. We remain on track with our full year outlook for cash and continue to expect to grow our free cash flow to about $3 billion by 2025. This represents a greater than 20% CAGR driven by the growth of our business and structural tailwinds from cash taxes, lower CapEx and higher CAS recoveries. In over the next five years, we see an opportunity to approximately double our current level of free cash flow. Lastly, we continue to execute our balanced capital deployment plan. This includes investments of over $2.8 billion in R&D and CAPEX this year and returning excess capital to shareholders via our quarterly dividend and share repurchase plans.

For the year, we continue to expect to return over 100% of our free cash flow to shareholders, including roughly $1.5 billion in share repurchases. We also plan to retire $1 billion of notes that mature in August, and we don’t have any additional bond maturities until 2025. Overall, the Northrop Grumman team delivered a strong first half of the year, our business strategy is working and we’re continuing to drive additional growth in sales earnings in cash. With growing global demand for a portfolio of solutions and solid program performance. We’re building long term value for all our stakeholders. With that, let’s open up the call for questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Robert Stallard with Vertical Research you may proceed.

Robert Stallard: Thank you so much. Good morning.

Kathy Warden: Good morning.

Robert Stallard: A couple of questions from me. First of all, Kathy, thanks for your commentary on the margin expectations for the next few years. But I was wondering, as you talk about this, what are you expecting on the B-21 LRIP? Is that still anticipated to be around a sort of breakeven margin in your expectation? And then secondly, does the end of the F-18 have an impact on this?

Kathy Warden: Rob, thanks for the questions. So as we look at the profile going forward for B-21 as we’ve noted before, we are not planning to have margin from the LRIP contracts. So when I talk about our Merchant projections going forward and anticipate that I will remind you we still have the risk factor associated with B-21 as we look at inflationary impact. In the quarter, we did receive notification that the DOD has allocated $60 million for B-21 LRIP procurement due to inflationary impact and we expect that to be awarded later this year. But keep in mind, this only applies to the one fiscal year it’s associated with FY ’23 and we continue to work closely with the government on an effort to address the impacts of macroeconomic disruptions.

With regard to your question about F-18. Yes, our projections also incorporate the wind down of the F-18 production line. We have been anticipating that it is built into our plans if we think about our production profile over time, that mix is being driven not just with aerospace programs like B-21, transitioning to production and F-35 continuing to grow. It is built on our entire portfolio. All four of our segments will see programs shifting from development to production in that timeframe and that mix shifting. Okay, then just a quick follow up on the HALO program. Could you clarify if this is a fixed price development program or if it doesn’t, has a different contractual structure? Thank you.

Kathy Warden: It is a fixed price program. We had worked with the government in a cost plus structure through the preliminary design review. So we had a more mature design before transitioning into a fixed price contract structure. And as I noted in my comments, we’re being even more disciplined moving forward in ensuring that we work with the government to have the appropriate use of fixed price contracts. We think that is best applied for commercial items or production programs with stable requirements in mature design is it’s turning out on the HALO program. The requirements are not as stable as we or the government anticipated. And we’re working with them to address that change management as we go forward.

Operator: Thank you, one moment for questions. Our next question comes from Richard Safran with Seaport Global Partners. You may proceed.

Richard Safran: Kathy, David, Todd, good morning. How are you?

Kathy Warden: Good morning.

Richard Safran: So, you’ve been a bit reluctant to talk about this so far, but I thought I’d see if you’d comment on the NGAD Sixth-Generation Fighter Program since the Air Force just recently announced the competition. What I’d like to know is if you’re thinking about bidding this as a prime, and I’d also like to know if you could, if this program is considered part of your, your growth strategy, so any color you could provide that would be helpful. Thanks.

Kathy Warden: Thanks, Rich. Yes, before the government officially announced the program and they’re intend to issue the RFP we had been quiet. But we have notified the U.S. Air Force that we’re not planning to the NGAD RFP as a prime. We are responding to other bidders request for proposal as a supplier that’s particularly in our mission systems portfolio. And as I noted in my remarks, we are remaining disciplined in assessing the right programs to pursue. And that’s ones where we feel we’re well positioned with a mature offering. And with the business deal reflects an appropriate balance of risk and reward for both the customer and the industrial base. So the [novice] decision on this program doesn’t impact our path to sales and earnings growth at [NGAD] we have a strong backlog in that sector and we have other opportunities and military aircraft that we are pursuing.