Northrop Grumman Corporation (NYSE:NOC) Q3 2023 Earnings Call Transcript

Northrop Grumman Corporation (NYSE:NOC) Q3 2023 Earnings Call Transcript October 26, 2023

Northrop Grumman Corporation beats earnings expectations. Reported EPS is $6.18, expectations were $5.81.

Operator: Good day, ladies and gentlemen, and welcome to Northrop Grumman’s Third 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 Ernst: Thanks, Josh, and good morning, everyone, and welcome to Northrop Grumman’s Third Quarter 2023 Conference Call. On the call this morning, we’ll refer to a presentation that is posted on our IR website. Before we start, 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.

A futuristic electric vertical takeoff and landing aircraft soaring through the sky.

On the call today 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 Warden: Thanks, Todd. Good morning, everyone. Thank you for joining us. We are all witnessing significant geopolitical tensions across the globe, including the ongoing war in Ukraine and the horrific attacks in Israel. We truly hope that peace and safety can be established for the people in these regions, and we’ll continue in our steadfast support for the U.S. and our allies in their pursuit of global security and stability. On this morning’s call, in addition to reviewing our third quarter results and important program events in the quarter, I’ll address the U.S. budget and trends we see in the global environment. And as usual, at this time of year, I’ll provide our initial outlook for next year. So starting with the quarter.

Our book-to-bill was 1.5x with approximately $15 billion in awards, and our sales increased 9% year-over-year with growth across all four of our business segments. Our backlog now stands at $84 billion. It’s a new record, and it strengthens the foundation for our future growth. It also continues to reflect the alignment we have with our customers’ priorities and the continued success of our business strategy. Segment operating income increased by 8% year-over-year, and the OM rate increased over last quarter. Earnings per share were $6.18, up 5% compared to last year. Strong earnings rose nearly $900 million in free cash flow in the quarter, and we remain on track to achieve our 2023 free cash flow target. Excellent cash generation continues to provide us the flexibility to invest in our capabilities and capacity while returning capital to shareholders.

We remain committed to returning over 100% of our free cash flow to investors this year, including $1.5 billion of share repurchases. And year-to-date, we’ve returned approximately $2 billion to shareholders in dividends and repurchases. So turning now to the U.S. defense budget. As is common in recent years, the federal government is operating under a continuing resolution to start fiscal year 2024. We’re encouraged by bipartisan support for national security priorities and are hopeful an agreement will be reached on full year appropriations soon. Our guidance and outlook assume a full year budget is passed by the end of this calendar year or early next year. And as we saw last week, the administration continues to make supplemental request for urgent needs, including those in Ukraine and Israel to include investments in weapon systems and defense industrial-based readiness.

The federal government is also developing its budget plans for fiscal year 2025, which we expect to be submitted to Congress early next year. We are working closely with our customers to plan for future capabilities and navigate the fiscal pressures they see to ensure our programs remain well supported. As we have been discussing throughout the year, we are also seeing an increase in international demand for our capabilities. We’ve seen a particular increase in our weapon systems portfolio and missile defense technologies like the IBCS product line. One notable example of this growing demand is with AARGM-ER where we’ve now received interest for more than a dozen countries and just this week, the opportunity for a foreign military sale to Finland was announced.

We are also working with the U.S. government to provide new advanced weapons capabilities. During the second quarter, we received a $705 million contract from the United States Air Force to develop the Stand in Attack weapon, also known as SAW, an air to ground weapon with the capability to strike mobile defense targets. Our SAW offering builds on the capabilities we provide with our high-speed AARGM missile, which is in production. Building off a mature product baseline, we’re able to reduce the developmental time, cost and risk to the SAW program. These missiles are expected to be the air-to-ground weapon of choice for the F-35 and other fighters. In our Space business, we remain focused on being at the forefront of technology, and that strategy has enabled us to build a differentiated portfolio that provides end-to-end solutions for our customers.

from new space architectures to launch capabilities. We see broad applications for the technologies we’ve developed with a particular focus on national security missions. This includes helping to turn the Space Development Agency’s vision of a new low earth orbit constellation of satellites into reality. In August, we were awarded a $712 million contract to design and build 36 satellites for SDA’s tranche two transport layer data constellation. With this award, along with our work on SDA’s tracking layer and tranche one of the transport layer, we are now building nearly 100 satellites for the proliferated war fighter space architecture. Our success in this area highlight our ability to compete and win in highly competitive and dynamic new markets within the space domain.

In addition, we had two notable launch events in the quarter. We successfully launched our 19th resupply mission to the International Space Station as we continue to execute under NASA’s commercial resupply contract. And five of our GEM 63 solid rocket boosters helped to power ULA’s Atlas V launch of a national security payload. These rocket motors will continue to support future ULA launches to include ULA’s Vulcan rocket. For next-generation interceptor, we successfully manufactured the first set of solid rocket motor cases in August, and we’re on track for our preliminary design review in the fourth quarter, more than a year earlier than the original contract date. These are just a few examples of the focus we have on strong program performance across the portfolio.

Now before I turn the call over to Dave to provide more details on the quarter, I’d like to provide some initial color on our 2024 outlook. We continue to see solid growth across all four of our businesses. with sales growth of approximately 4% to 5% compared to our latest 2023 guidance, which we’ve now raised by $800 million throughout the year. We also expect operating income to grow by 4% to 5% year-over-year. We reaffirm our free cash flow outlook range of $2.25 billion to $2.65 billion in 2024, which accounts for continued investment in the capabilities and capacity needed to grow our business and support our customers. So in summary, Northrop Grumman is well positioned to drive value creation for our customers and our shareholders. We are focused on executing our strategy, driving operating performance and generating cash for our disciplined capital deployment.

So now with that, I’ll turn it over to Dave to provide some more details on the segment results, 2023 guidance and our outlook.

David Keffer: Thanks, Kathy, and good morning, everyone. As Kathy described, we generated another strong quarter of results. The business is well positioned in growing segments of the market, and we’re delivering key capabilities that address our customers’ missions. As macroeconomic conditions improve, and pension and tax cash flow headwinds reverse over the next few years, we have a great opportunity to create value for shareholders through substantial cash flow growth, consistent with our long-term strategy. Taking a look at our demand metrics, we ended the third quarter with a record backlog of $84 billion, bolstered by several new competitive awards. And as a result, we now expect our full year book-to-bill ratio to be well over 1x.

Turning to the top-line, we continue to build on our momentum from the first half of the year, with overall sales growth of 9% in the third quarter. This includes growth in all four of our segments for the second straight quarter as our teams continue to ramp up new wins, add new talent and manage through continued pressures in the supply chain. At the segment level, Aeronautics posted sales growth of 90%, driven by higher volume on manned aircraft programs. DS grew by 6% on continued strength in their missile defense and armaments portfolios, including IBCS, GMLRS and HAKM. Mission Systems continued to generate rapid growth of restricted sales in the Network Information Solutions business, driving their top line up 7%. In Space again delivered double-digit sales growth as a result of the continued ramp on programs like GBSD, NGI, OPIR and several in the restricted domain.

Moving to segment margins. We’re pleased with these bottom line results in a dynamic environment. In total, segment operating income grew by 8% compared to the third quarter of last year. As we expected, we delivered an incremental improvement in our segment OM rate from earlier quarters this year, expanding to 11.1% in Q3. Program performance remained strong across the portfolio. Our Aeronautics and Defense businesses generated a healthy volume of favorable EAC adjustments through efficient execution and risk retirements. MS margins were down slightly as mix shifted to more cost-type development efforts, particularly in their restricted portfolio. In that space, given the rapid backlog growth we’ve experienced, strong execution and program performance are our top priorities.

Space margins improved by 80 basis points this quarter compared to Q2. Diluted EPS in the third quarter were $6.18, up 5% from the prior year. The increase was driven by higher sales and segment performance, along with a lower share count. We also recognized a gain from the sale of an Australian minority investment in Q3 that we described on prior calls and included in our guidance. Partially offsetting these items was lower net pension income of roughly $1 per share, a nonoperational impact consistent with the first two quarters. Q3 was a strong period for cash generation with free cash flow of nearly $900 million. On a year-to-date basis, this brings us to nearly $500 million of free cash flow, well ahead of where we were at this time last year.

We continue to remain disciplined in managing our working capital, and we saw improvements in these accounts across the company in Q3. With respect to cash taxes, the IRS recently provided additional guidance on the amortization of research and development expenditures under Section 174 of the tax code. This guidance did not change our interpretation of the provision. But upon finalizing our 2022 tax returns, we lowered our estimates for Section 174 cash taxes based on applicable R&D costs that were below our original estimates. Offsetting the lower 174 taxes is an increase in other tax items, the net result of which is a multiyear cash tax forecast that is roughly unchanged. Moving to 2023 guidance, I’ll begin with a few updates to our segment estimates as shown on Slide seven in our earnings deck.

First, based on the strength of our year-to-date results, we now expect modestly higher sales in our Aeronautics business in the mid- to high $10 billion range. This represents a return to growth this year at AS, a year earlier than expected, and continues to assume that we will be awarded the first LRIP lot on the B-21 program in the fourth quarter after first flight. The Air Force said in September at the AFA Conference, we are progressing through ground testing, and we’re on track to enter flight testing this year in line with the program baseline schedule. And we are again increasing our top line expectations for our Space segment based on new wins and continued strength in this business. We now expect 2023 sales of approximately $14 billion, which represents year-over-year sales growth of 14%.

For operating margin rate, we’re projecting a slightly lower operating margin rate at MS to reflect their year-to-date trend line. Other segments are unchanged. At the enterprise level, we’re increasing our sales guidance by another $400 million and now expect 2023 sales of approximately $39 billion. This represents year-over-year growth of roughly 6.5%. We are maintaining our guidance for segment operating income. Year-to-date trends would indicate figure towards the lower half of that range, and we’re reaffirming our estimates for EPS and free cash flow. Next, I’ll build on Kathy’s comments on our 2024 outlook. Sales growth has accelerated sooner than we expected in 2023, and we continue to project growth at all four of our business segments next year.

We expect segment margins in the low 11% range, and we continue to project improvement over time as we see benefits from the stabilizing macro environment, our cost efficiency initiatives, and our business mix improvements. We continue to anticipate CapEx to be roughly consistent as a percentage of sales in 2024 before declining in 2025 and beyond. And shareholder returns will remain a top priority for our free cash flow deployment, including returning at least 100% of free cash flow to shareholders next year. Given the volatility in the financial markets, I’d also like to provide a quick update on our pension plans. Our funded status is now above 100% as of the end of Q3. And we continue to expect minimal required cash contributions over the next several years.

This is a discriminator for us that supports our affordability and competitiveness as well as our capital deployment optionality. Given that our GAAP earnings per share are affected by net pension income, as we did last year, we have provided a pension income sensitivity table for 2024 on Slide 9. Our forecast in early 2023 was predicated on asset returns of 7.5% and a discount rate of roughly 5.5%. Through September 30, financial market movements have led to a roughly 50 basis point increase in discount rates and a year-to-date asset return of 1% to 2%. This combination of results would reduce net FAS pension income and increased CAS recoveries from our prior projections. Based on the sensitivities highlighted on the slide, the net result would be an impact to 2024 GAAP EPS of roughly $0.50 compared to our initial outlook provided in January.

Keep in mind that FAS pension income is noncash in nature. Higher CAS estimates would provide a modest benefit to our cash flows but could have a modest downward impact on EACs in the quarter in which they are updated, consistent with this year’s pattern. Speaking of cash flow, we continue to see a path to grow our cash flows at a greater than 20% CAGR next year and through 2025 with further expansion in the following years. As is our practice, we’ll provide our latest multiyear outlook for free cash flows on the January earnings call. We remain confident in the long-term value creation opportunity from free cash flow expansion and disciplined capital deployment through the rest of the decade. With that, let’s open the call up for questions.

Operator: [Operator Instructions] Our first question comes from Douglas Harned with Bernstein. You may proceed.

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Q&A Session

Douglas Harned: In Aeronautics, you’re raising your top line guidance. Dave, you talked about this. I mean, Kathy, we’ve talked about this subject many times, with the valley that you had kind of forecast for revenues this year as legacy programs declined. But things are getting better. So what are the puts and takes here that appear to be starting you on a growth path going forward? And given the mix, do you still see Aeronautics is able to maintain 10% margins in the coming years?

Kathy Warden: Thanks, Doug. So the puts and takes that we’ve been talking about have materialized as we expected. The biggest factor was the programs that were declining are largely through our year-over-year comparison now. Those include Global Hawk, which is in sustainment; Triton, which is still in production. But as we look forward, that rate is fairly stable and so it is not contributing to significant growth. What is contributing to growth is B-21, and we expected that ramp to start this year and continue and we still anticipate that. And then other stabilizing factors of the F-35, E-2D large programs that have generally remained constant. As we look forward, we see that same profile in those program categories, and that will contribute to growth at AS.

We do expect that margin rates will be near that 10% mark that we’ve been talking about. And we’ve gone through, again, those major categories of the portfolio and how they contribute. Our mature production is about 60% of the portfolio and that tends to have above 10% margins, whereas the B-21 has contributed lower margins and will, as we move into production, contribute 0 on the production. That’s our planning assumption, of course. And so it’s the mix of that entire portfolio that brings us to that approximately 10% expectation toward the near to midterm.

Douglas Harned: And then when you look forward into 2024, I know in the guidance today, you said 4% to 5% increase in sales, 4% to 5% increase in operating income. I mean that implies really no margin expansion overall in 2024. Can you talk about that and just how you’re thinking about margin progression going forward?

Kathy Warden: Absolutely. So at this point in the year, as is normal, we wanted to provide an outlook. They are broad ranges. So the 4% to 5% both for sales and operating margin, it gives us opportunity to do further planning and characterizing of the budget as that becomes more clear, and we’ll provide more precise guidance in January. What I would say is that we are still on track for the trends that we have spoken of in operating margin. We see improvements, and that is reflected in our guidance for 2023 in the fourth quarter, again, sequential improvement over Q3 performance. And we expect as we move into next year, there are continued opportunities for improvement in operating margins. They are related to macroeconomic trends largely inflation, labor cost, productivity.

And so we’d like to get a little bit more time under our belt before we get concrete about what that improvement might look like. So we are expecting some modest margin rate improvement into next year as we have outlined for Q4 of this year. I also just want to point to the fact that the free cash flow growth is the real point for our investors to understand, while earnings growth will be there, we also have headwinds that have historically in the last couple of years, challenged us on free cash flow that are dissipating. We’ve talked about — and I’m sure we’ll talk more on today’s call about Section 174, which is a decreasing headwind over time. We also see the pension headwind curtailing. And then, of course, since we reduce our CapEx spend starting in 2025, even more robust free cash flow growth.

But looking at 20% year-over-year free cash flow growth is really an important milestone for us. and something we’re very focused on delivering.

Operator: Our next question comes from Ronald Epstein with Bank of America. You may proceed.

Ronald Epstein: Yes. Across the industry, there’s been a lot of discussion about from supply chain capacity constraints, labor constraints. One thing that’s popped up in a lot of discussions is just the availability of solid rocket motors for missiles and so on and so forth. Just broadly, Kathy, how is Northrop handling? You’re getting a surge in demand at a time where kind of post COVID and all that, I mean, labor has been tough and supply chains are tough. I mean how is it going? And what’s Northrop doing to handle that?

Kathy Warden: Ron, we got ahead of seeing the demand, not quite to the degree that the demand has increased in the last 18 months, but we had forecasted an increase in demand, particularly in our solid rocket motor business, but broadly as we’ve been ramping up for production of satellites, aircraft and mission systems capability across the board. It’s why our CapEx has been elevated. And so first and foremost, we did what’s necessary, and that is invest in our workforce and our facilities to be able to support that demand. And it’s what’s allowing us to support both our direct customers and prime who are now coming to us at for that capability. We are going to continue to do that, and that’s why we still have some robust CapEx plans in place for 2024 reflected in the outlook we provided.

We are seeing labor back to pre-pandemic levels in terms of our ability to hire, retain. Certainly, inflation is causing more labor rate escalation than we saw pre-pandemic, but we are able to get the workers that we need. Our focus now is on productivity. And there too, we’ve invested in training. We’ve invested in standard work instructions in digital technology, all of which are enabling productivity in our workforce. That has been a little slower to materialize with our supply chain. And so we are spending a lot of Northrop Grumman resource with our suppliers, co-locating with them. and helping them to improve productivity as well. And once we remove that bottleneck, I think we’ll, as an industry, be able to no longer have capacity to be our constraining factor.

But with that said, and now we’re looking at a supplemental and growing international demand, all of which continue to add to the demand equation. So we are still going to be a bit in a catch-up mode because it does take generally 18 to 24 months to lay in new capacity to support that demand.

Ronald Epstein: Got it. Got it. And then maybe a follow-on for Dave. Is there — can you give us any update on how you’re thinking about the B-21 LRIP? Because that’s something that’s kind of always on everybody’s mind.

David Keffer: Sure. It’s Dave. So we continue to anticipate, as we noted in the earlier part of the call that the first LRIP contract will be awarded in the fourth quarter. That’s consistent with our expectations that we’ve described throughout the year and reliant upon first flight occurring between now and that LRIP contract award. And we continue to evaluate our performance and our outlook on the LRIP phase of the program each quarter and did not make any significant changes to our estimates for that phase during the third quarter. So we’ll continue to update everyone over time as we have updates.

Operator: Our next question comes from Sheila Kahyaoglu with Jefferies. You may proceed.

Sheila Kahyaoglu: Kathy, you highlighted a few moments ago that free cash flow growth is the real story here. So I want to focus on that since you mentioned it. Can you talk about multiyear free cash flow growth? You’ve done so in the past. But how do you think about the biggest drivers from a top line networking — net income drop-through tax CapEx perspective?

David Keffer: Sheila, it’s Dave. I’m happy to provide some additional color there. The 2024 updates that we provided on the call today should give you a sense for our near-term sales and earnings growth expectations underlying that free cash flow expansion. We do expect to continue to see a leading sales profile in the growth of our business. And as we’ve talked about, we anticipate long-term margin expansion opportunity as well. And so both of those are foundational to our multiyear free cash flow growth expectations. On top of that, we’ve talked about the last couple of years that the 2023 and 2024 would be a period of peak capital intensity for the business, and that is consistent with our current expectation. Large programs that we’ve had for a number of years as well as new wins we’ve had that have grown our backlog so significantly over the past couple of years have all contributed to a peak period of capital intensity right now that we have clarity on sources of decline in the middle of the decade.

And so we expect that capital intensity to be alleviating in 2025 and beyond. Working capital performance is really among the best in class at this point. And even with a modest headwind from the progress pay changes, we anticipate continuing to be able to deliver stable working capital performance, not a meaningful driver of headwind or tailwinds there. And then you get to the two items Kathy mentioned earlier, modestly higher CAS pension recoveries currently projected over the next few years. Of course, those will continue to fluctuate based on — primarily on asset returns, but other actuarial changes that are possible as well. And then on the cash tax side, as we’ve noted, a pretty stable outlook for free — for cash taxes from what we’ve been anticipating previously, and that outlook is for declining cash taxes over the next several years largely driven by the Section 174 movement as we get through the period of amortization over these five years.

So all in all, a number of key tailwinds most critical of which, of course, is the expectation of continued growth and margin opportunity in the business.

Operator: Our next question comes from Myles Walton with Wolfe Research. You may proceed.