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Northrop Grumman Corporation (NYSE:NOC)

Q3 FY08 Earnings Call

October 22, 2008, 12:30 PM ET

Executives

Gaston Kent - VP of IR

Ronald D. Sugar - Chairman and CEO

Wes Bush - President and COO

James F. Palmer - Corporate VP and CFO

Analysts

Joseph Nadol - J.P. Morgan

Myles Walton - Oppenheimer & Co.

Robert Spingarn - Credit Suisse

Ronald Epstein - Merrill Lynch

Doug Harned - Sanford Bernstein & Co.

David Strauss - UBS

Heidi Wood - Morgan Stanley

Cai von Rumohr - Cowen & Company

Carter Copland - Barclays Capital

Operator

Good day, ladies and gentlemen, and welcome to the Northrop Grumman Third Quarter Earnings Conference Call. My name is Carissa [ph] and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of today's conference. [Operator Instructions].

I'll now like to turn the presentation over to your host for today's conference, Mr. Gaston Kent, Vice President of Investor Relations. Please proceed.

Gaston Kent - Vice President of Investor Relations

Thank you Carissa, and good morning everyone. Welcome to Northrop Grumman's third quarter 2008 conference call. We've provided supplemental information in the form of a PowerPoint presentation that you can access on our Investor Relations website at northropgrumman.com.

The presentation will be available for a limited time and should be viewed in conjunction with today's commentary.

Before we start, please understand that as shown on slide two, some of the matters discussed on this call constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect the company's views with respect to future events and prospective financial performance. Forward-looking statements involve risks and uncertainties and the actual results of the company may differ materially from the results expressed or implied by the forward-looking statements.

A more complete expression of these risks and uncertainties is contained in the company's SEC filings including Forms 10-K and the 10-Q which was filed this morning.

During the call, we'll discuss third quarter results, including the non-GAAP measures, segment operating income, and segment operating margin and free cash flow both of which are reconciled in our press release. During today's call, we'll also discuss the outlook for the remainder of 2008. Guidance will include GAAP measures of sales, operating margin, earnings per share from continuing operations, cash from operations and non-GAAP measures, segment operating margin rate and free cash flow.

On the call today are our Chairman and CEO, Ron Sugar; our President and COO, Wes Bush; and our Chief Financial Officer, Jim Palmer.

Please go to slide three, and at this time I would like to turn the call over to Ron.

Ronald D. Sugar - Chairman and Chief Executive Officer

Thank you, Gaston, and hello everyone. Thanks for joining us. We're very pleased with our strong third quarter results. Sales and earnings per share both grew by 6%. These are solid improvements but the highlights of this quarter are cash generation, new business awards, and our record backlog. Cash from operations totaled $1.4 billion and free cash flow totaled $1.2 billion.

Strong cash generation and our ample liquidity supported the continued execution of our balance cash deployment strategy. During the third quarter we purchased more than 10.8 million shares of our stock bringing our year-to-date share repurchases to approximately 21.2 million shares. At the end of the quarter we had approximately $960 million remaining on our share repurchase authorization. Shortly after the end of the quarter we purchased 3001 International, a strategically important IT sector acquisition that will significantly complement our current core geospatial business with its strong geospatial data collection processing and production capabilities.

We ended the quarter with a record backlog of more than $70 billion. New business awards in the quarter totaled $11.5 billion and include new competitive awards as well as follow-ons to some of our large franchise programs. This brings year-to-date new business awards to more than $31 billion nearly equal to our 2007 annual sales.

During the quarter, we were awarded a $5 billion cost type construction contract for CVN 78, the USS Gerald R. Ford, the Navy's next generation Aircraft Carrier. Our second quarter awarded the Navy's $1.2 billion Broad Area Maritime Surveillance contract or BAMS was upheld by the GAO and we are underway now on that program.

In addition to new awards, we also achieved some notable program events during the quarter including completion of the electrical cabling milestone on the LHD-8. We are very pleased with how that program is progressing and we have increasing confidence in the delivery schedule for this ship. Wes will provide more color on this in a minute.

I also want to take a minute to comment on the air force tanker program. Clearly, as the wining bidder it's disappointing that the competition has been deferred. We are also genuinely disappointed on behalf of the men and women who urgently need a new tanker. The air force chose the right tanker during the first competition and we are convinced that when we compete again we will win again. We continue to have a very robust opportunity set in addition to the tanker. The down select on the multibillion dollar joint like tactical vehicle program is imminent. Also on the horizon are programs like Aerial Common Sensor, GPS Next Generation Ground Control segment, Vehicular Intercommunications Segment Next Generation and other substantial new opportunities including restricted programs.

Before I conclude I want to take a moment to comment on the turbulence in the capital markets, the responses from the federal government and how Northrop Grumman is likely to fair going forward. Our business is characterized by long-term contracts that support national security priorities. We believe military spending priorities and specific program spending plans are primarily threat driven. These threats will exist regardless of the changing political or economic backdrops.

Overall Northrop Grumman's programs were well funded in the recently past 2009 defense budget. While we are mindful that the higher level of Federal Government spending through the Emergency Economic Stabilization Act and other Federal financial support programs make pressure defense spending, the budgetary process gives us good visibility regarding future spending and the threats being addressed. We believe that our strong contract backlog is well aligned with the direction of our nation's future security needs. The recent market turmoil has demonstrated the importance of liquidity and access to the capital markets. It is also heightened our level of vigilance regarding the financial health of our suppliers and our pension plan investment returns. While no business is completely immune to these pressures, we believe our backlog, cash generation and credit facilities will allow us to continue to grow despite these challenges. So in conclusion, this was a strong quarter in which we generated higher sales, earnings, free cash flow, and new awards. Based on that strength we are raising our 2008 guidance for sales and earnings per share.

Now I'd like to turn the call over to Wes Bush. Wes?

Wes Bush - President and Chief Operating Officer

Thanks Ron. Hello everyone. My comments today are outlined on slide 4, and we'll focus on two key thrusts of our operating improvement efforts: business capture and program execution. We put tremendous effort into enhancing our business capture operations over the past several years and the results are showing.

A key indicator of course is the growth in our contractual backlog which now stands at over $70 billion. Key wins this year such as BAMS demonstrate the competitive improvements in our process. But as importantly, we're driving to improve the quality of our new contracts through adherence to our new more stringent bid criteria. We are not bidding on programs unless they meet those criteria. And you can see the effects of this for example in our declining sales and backlog in the commercial state and local business of our IT sector. So we're being more selective, our total backlog is growing and the quality of that backlog is improving.

Program execution is also a key operating priority in the company. And here too we're making progress in our portfolio of over 20,000 programs as we integrate stronger risk management methodologies into our program management processes.

We are making good progress and retiring risk on our key watch-list programs. On Block 60 we met our milestone for delivery of the EW3 software in the quarter, and we continue to perform to plan. On Wedgetail we are ready to enter type acceptance testing once clearance is obtained from the customer. And we've reduced the staffing on the effort while we await this go ahead in order to maintain performance within the EAC. During the quarter we undertook an extensive review of the risk on the New York City wireless program and we determined that while we're making very good progress, cost to complete the work has increased. Some of this relates to our estimate of additional cost that we may incur to ensure that we can obtain the equipment and the support that's needed to complete the program from a key sub contractor who is currently experiencing some financial difficulties.

In addition to these potential subcontractor related costs, the provision also reflects a revised estimate to complete the program. As build out has progressed we've encountered cost growth associated with site completions and some slower regulatory permitting which is extended in network completion schedule into the first half of next year. We believe this revised estimate appropriately reflects the remaining work as we've made good progress towards completion of the program. The technical performance is outstanding and we've already achieved 90% coverage of the city with the network.

Our ship building team is making solid progress. Our submarine and aircraft carrier programs are going very well. We suffered some downtime in our Gulf Cost operations duet to Hurricane Gustav and Hurricane Ike caused damage at the subcontractor facility that builds compartments for LPDs 22 and 23. Our team has taken aggressive management actions to minimize these hurricane impacts.

I'm very pleased to report on the outstanding progress that we are making on our HTA [ph]. Timely accomplishment of the third quarter electrical cabling milestone was absolutely critical and it totally supports our delivery timeline. As a result of this progress we returned some program reserve to profit in the quarter. We are on track to complete the pier side integration propulsion testing this quarter as well.

Based on this excellent progress to date we are working with the Navy to potentially accelerate builder trials and trial readiness reviews are already underway with the Navy's program team. So despite some issues including some externally driven challenges, we are making good progress and continual improvements in program execution and the quarter results demonstrate that the portfolio is operating well.

So with that I will turn it over to Jim.

James F. Palmer - Corporate Vice President and Chief Financial Officer

Thanks Wes. Good morning ladies and gentlemen, during my comments I will discuss sales and provide some color on margin rate and cash trends and then I will review 2008 guidance and then provide some thoughts regarding 2009 trends with some particular discussion on 2009 pension expense.

To begin on slide five, I want to provide my perspective on what is a very strong quarter. Our underlying fundamentals continue to be very strong as evidenced by higher sales, net earnings, free cash flow, record backlog, strong liquidity and access to capital.

Earnings per share are 6% better than last year; last year did include a $0.06 per share gain from the AMSEC reorganization so without that $0.06 gain of last year's third quarter earnings this quarter's year-over-year improvement would have actually been 11%. And when netted against each other the unusual items in this year's third quarter, New York City wireless the hurricane impacts that Wes talked about and the positive items, the royalty settlements and tax credits generated a $0.02 reduction in this quarter's earnings and the tax credits were anticipated in our guidance for the year.

Risk mitigation and program execution continue to be the highest priority of our senior management team. Across the company we are working diligently to reduce and retire program risk on programs so that our execution and financial results become much more predictable.

This quarter we also took a more conservative approach to program risk assessment particularly at our Gulf Coast shipyards which resulted in the lowering of booking rates on a number of those programs. And finally, we're working hard to ensure that we negotiate contracts that appropriately reflect the risk inherent in that work. As you all know, no amount of good performance can overcome a poor contract.

Moving on to slide 6, sales for information and services, aerospace, and electronics, are all up over last year and on a consolidated basis sales were up more than 6%. The third quarter sales trends for information and services and aerospace are consistent with what we've seen throughout the year. The increase though in electronics is largely due to increased deliveries in the third quarter. And the decline in ship building is due to Hurricane Gustav which required the closure of our Gulf Coast shipyards for more than a week and reduced sales by approximately $100 million in the quarter.

Year-to-date shipbuilding sales were up 11% and for the year we now expect their sales would total approximately $6.1 billion which exceeds our prior guidance of $5.7 billion to $5.9 billion. We also expect higher sales for aerospace than our previous guidance, which was $9.3 billion to $9.5 billion. We now expect aerospace sales will total approximately $9.7 billion. And electronic sales were expected to be about $7 billion. This is at the low end of our prior range and simply reflects the sales of the electrical... Electro-Optical Systems business earlier this year.

So based on year-to-date results in the increased expectations for shipbuilding and aerospace we are increasing our guidance for 2008 sales to $33.4 billion.

On a consolidated basis, segment operating margin totaled 9.2% compared to 10.4% last year. After adjusting for unusual items the underlying segment operating margin rate this quarter is fairly consistent with last year. Last year's rate of 10.4% when adjusted for the $67 million in shipbuilding positives and at 22 million information technology charge equates to 9.8%. This quarter's rate would have been 9.7% before the $40 million patent infringement settlement in the New York City wireless charge and the hurricane impacts.

Below the segment line, improvements in unallocated expenses and net pension expense were offset by the decline in operating income and the reversal of the royalty income leaving us with a total operating margin rate of 9.2% for the quarter.

Looking at the year-end total we now expect both segment margin rate and total operating margin rate to be in the mid 8% range. This adjustment to prior guidance contemplates a margin rate of mid 7% for information and services versus the prior guidance of low 8% and a mid 2% range for our shipbuilding versus the guidance of approximately 3% to 4%. The reduction in the shipbuilding rate is largely hurricane driven.

Moving to taxes, our effective tax rate declined to 31.4% in the quarter primarily due to the settlement of TRW tax audits for the years 1999 through 2002 which had been anticipated in our tax rate guidance for the year. During the third quarter we recognized tax credits of about $21 million primarily attributable to the settlement and with the passage of the Emergency Economic Stabilization Act of 2008 and the renewal of the R&D tax credit, we now expect an effective tax rate for the year of about 33.5%.

Looking at cash on slide 7, cash from operations was just outstanding at approximately $1.4 billion for the quarter, a substantial improvement over last year's $1 billion mark. In the quarter trade working capital improved by more than $400 million reflecting a continued emphasis on managing working capital as well as the successful resolution of billing transition issues we discussed on previous call this year.

Year-to-date, trade working capital was essentially flat while the company is growing by 6%. After capital spending and outsourcing contract cost, free cash flow improved to $1.2 billion. This translates to a net income conversion rate of a 128% on a year-to-date basis.

Slide 8 summarizes our updated guidance for 2008. We now, as I said expect sales of $33.4 billion and earnings per share of $5.10 to $5.20. Our guidance for cash from operations remains at $2.6 billion to $2.9 billion and for free cash flow we have targeted a net income conversion of greater than a 100% for the year. The lower end of our free cash flow range has improved by $100 million to $1.8 million while the upper end remains at $2.1 billion. This cash from operations and free cash flow guidance includes a $120 million for required pension contributions. We are contemplating the additional voluntary contributions to the pension plans which would reduce reported cash from operations and free cash flow.

Looking ahead to next year, I'd like to take a moment to provide some perspective on 2009 FAS and CAS pension expense including some sensitivities. Chart 9 in your package summarizes my comments. As you know 2009 FAS pension expense will be determined based on actual investment rates for 2008 and the discount rate as of December 31st. And as you know unlike many of our peers we have had a long term historical practice of using actual fair market value of planned assets at year-end to determine our next years expected investment returns.

Through September 30th, our actual investment returns were a negative 12%. Although significantly different than our long-term investment rate of return assumption of 8.5%, it is decidedly better than the market in general. And this return is also significantly different than our long-term historical experience. Over the last 30 plus years we have realized a compound rate of return of about 11% annually in our pension plan. Earlier this year we made a change in our investment policy significantly reducing our... the equity rating. This has been a beneficial change as equities have underperformed the other investment classes this year.

Now let's talk a bit about how this performance will be reflected in future pension expense. With the current market volatility, a lot can happen between now and the end of the year but we had previously modeled a negative 10% investment return on planned assets for 2008 compared with that 8.5% long-term rate of return assumption and a discount rate of 7% versus the 6.25% that we used at the end of the last year. And frankly if we were setting these rates at 9.30, the discount rate for example would likely have been higher. But as I said we set these rates at the end of the year.

But under these modeled conditions and recognizing the differences in the individual plans our net 2009 FAS/CAS pension adjustment would be an expense of about $165 million compared to income in 2008 of about $250 million. I think it's also to provide... I think it's also important that I provide some sensitivities to these modeled assumptions.

I must caution you however that these sensitivities are unique to our situation and this model. As you may know, cumulative pension gains and losses are first absorbed into a quarter equal to the greater of 10% of planned assets while projected benefits with any excess gain or loss then amortized into an expense. So these sensitivities are relatively linear once we are outside that 10% corridor. So with every 100 basis points move at a variance around the assumed negative 10% investment return we see a change of approximately $40 million in estimated 2009 FAS expense.

Like wise for every 25 basis point change in the assumed 7% discount rate it results in a change of approximately $50 million in estimated 2009 FAS expense. In addition if we decided to pre-fund our pension plans between now and early 2009, we would further reduce our 2009 FAS expense by $8.5 million for every $100 million of voluntary pension funding.

In looking at 2009 CAS expense and required cash contributions we do not expect to see the same level of volatility as CAS and cash are less sensitive to the current market movement until we reach a breakpoint somewhere above a minus or a negative 20% investment return.

So let me pause and then just transition to some comments about the overall outlook for 2009. As you know we will give a specific guidance with our fourth quarter earnings call as is our normal practice. But I would like to give you some indication of trends that we currently see.

Regarding total operating margin rate, as we discussed, given the current marketing conditions we expect the net FAS/CAS pension adjustment to increase, become negative actually in 2009. Secondly, we expect substantial improvement in shipbuilding margins. Thirdly, we don't expect the same level of royalty income as we have seen in 2008, and for sales we expect to see continued growth now based on our new business awards and strong backlog that we've experienced on a year-to-date basis. And finally I would expect that the strong cash generation capability of the company to continue into 2009. Gaston, I think with that we are ready to turn it back over to you for questions and answers.

Gaston Kent - Vice President of Investor Relations

Great, thanks Jim. Carissa, we are ready to go. Q and A please.

Question And Answer

Operator

[Operator Instructions]. And your first question comes from the line of Joe Nadol of J.P. Morgan. Please proceed.

Joseph Nadol - J.P. Morgan

Thanks, good morning.

James F. Palmer - Corporate Vice President and Chief Financial Officer

Good morning Joe.

Ronald D. Sugar - Chairman and Chief Executive Officer

Hi Joe.

Joseph Nadol - J.P. Morgan

First question is on backlog and bookings. It looks like some good performance. The one area there that looks like it was down a little bit is Space. I was just wondering if you could comment on some of the things going on in Space, we've seen some delayed programs and that sort of things, any color would be helpful?

Ronald D. Sugar - Chairman and Chief Executive Officer

This is Ron, Space tends to come in lumps so it tends to be a variable. So in a given quarter you may not see much, next quarter you may see a significant amount to small number of large programs. I think that's probably the way to explain that.

Joseph Nadol - J.P. Morgan

Right. Just a little bit of trend though, I am looking at the nine months number and big picture with TSAT, looking like its getting pushed out, any thoughts Ron, big picture on the industry.

Ronald D. Sugar - Chairman and Chief Executive Officer

Yes, obviously TSAT will put some pressure on our future growth in that area, on the other hand we have a lot of other things cooking as well Joe. So I would say that what you are seeing is basically the quarter-to-quarter fluctuations and awards.

Joseph Nadol - J.P. Morgan

Okay and then secondly on the LHD 8, Wes, you mention that there was a slight reversal of the reserve into profit. Can you quantify that and can you give us a sense as to how much more opportunity there might be if you continue to hit these milestones.

Wes Bush - President and Chief Operating Officer

Yes, Joe. As I said we are making really good progress on LHD 8. We had a positive $34 million on the return to profit in the quarter because of the progress we have made to date. At the same time though we took a change in the booking rates, a more conservative approach looking across our full set of shipped programs, but essentially offset it, it was a little bit more. I think it was around 36 million.

Joseph Nadol - J.P. Morgan

Right.

Wes Bush - President and Chief Operating Officer

And so together we view that as an appropriate way of looking at where we are on the programs. LHD 8 continues to perform well. I wouldn't want to speculate on what the future might hold in that regard as we go forward because we still have some very important milestones to accomplish and finally we are delineated in my remarks on that slide. But I am feeling better and better about how we're doing as we continue to clip these milestones off.

Joseph Nadol - J.P. Morgan

Okay. So just to be clear the 36, how is that really to the... the 16 million that you noted in your press release on the subcontractor disruption that's exclusive of that, it was the three independent items?

James F. Palmer - Corporate Vice President and Chief Financial Officer

Three independent items, yes Joe. The hurricane impacts essentially Gustav was 16, Ike was 11, and then you have the LHD 8 for...

Ronald D. Sugar - Chairman and Chief Executive Officer

Gustav was 11, Ike was 16.

James F. Palmer - Corporate Vice President and Chief Financial Officer

Yes, I'm sorry. Hurricane effects were 27, and then you had LHD-8 for a positive 34 and approach on a... essentially a risk assessment or a more conservative risk assessment on the other programs of a minus 36.

Joseph Nadol - J.P. Morgan

Okay. And then, during that note finally I'll let someone else go. On that 36, what were the drivers of the adjustment there? Was it workforce buffer --?

James F. Palmer - Corporate Vice President and Chief Financial Officer

It really is taking a more conservative view of the risk associated with the programs, looking at each of the individual contracts and the risk associated with completing them. As you guys know, shipbuilding is characterized by programs or contracts that take many years to complete. And so we just thought it was appropriate to be a little bit more conservative in our view about the risk of completing those programs.

Joseph Nadol - J.P. Morgan

Okay, thank you.

Ronald D. Sugar - Chairman and Chief Executive Officer

Thank you, Jeff.

Operator

Your next question comes from the line of Myles Walton of Oppenheimer. Please proceed.

Myles Walton - Oppenheimer & Co.

Thanks, good morning.

Ronald D. Sugar - Chairman and Chief Executive Officer

Good morning, Myles.

Wes Bush - President and Chief Operating Officer

Hi Myles.

Myles Walton - Oppenheimer & Co.

So I want to talk about pension a little bit. So first, can you give us where the plan is as of today, given the October market performance? Can you give us a hand there?

Ronald D. Sugar - Chairman and Chief Executive Officer

Let's see Myles. Easy to get for the end of September, we were minus 12 at the end of September. The market performance in October as you know has been poor. Our estimate at this point would take that minus 12 to about a minus 20, maybe 21. It's really... but it's hard to get those exact numbers because of... for example, alternatives you don't value on a daily basis. But it looks like kind of the minus 20 to minus 21.

Myles Walton - Oppenheimer & Co.

Okay. And then you mentioned a 20% breakpoint, which I guess you could go... what changes at that breakpoint?

Ronald D. Sugar - Chairman and Chief Executive Officer

Essentially at the breakpoint, the CAS starts moving in concert with FAS, and so the net difference actually improves, the CAS actually moves greater than FAS after the break point and so the net difference actually declines a little bit after that point.

And depending upon how for fast we go by that breakpoint, cash contributions... required cash contributions would increase somewhat. But probably in the couple hundred million dollar range.

Myles Walton - Oppenheimer & Co.

Okay. I think I get that. And then, lastly on cash contributions. What is your tax-deductibility limit for this year? In the past you have obviously... I think you peaked out at about $1 billion in '06, is that kind of tax deductibility limit?

Ronald D. Sugar - Chairman and Chief Executive Officer

I don't know what the limit is. I don't know that we are effectively constrained in what we might want to put into the plan. But I don't know if there's a number that constrains us.

Myles Walton - Oppenheimer & Co.

Okay. Okay. Thanks, boring questions, but thanks.

Ronald D. Sugar - Chairman and Chief Executive Officer

All right.

Operator

Your next question comes from the line of Robert Spingarn of Credit Suisse. Please proceed.

Robert Spingarn - Credit Suisse

Good mornings guys.

Ronald D. Sugar - Chairman and Chief Executive Officer

Good morning Robert.

Wes Bush - President and Chief Operating Officer

Good morning.

James F. Palmer - Corporate Vice President and Chief Financial Officer

Good morning.

Robert Spingarn - Credit Suisse

Perhaps a follow-on boring question, same topic. Jim, if I understand correctly you just said 20%, 21%. Let's walk through what that means if that number holds for the end of the year. That looks like that's an incremental 400 million?

James F. Palmer - Corporate Vice President and Chief Financial Officer

Essentially, if you file those sensitivities to the outline, that would be about $400 million, if there is no change in the discount rate and if there's no recovery in the investment performance. And as I said we are in a very volatile market, you guys know that. If I look at our investment performance through August, we were at minus... kind of at minus 6%. So the last 45 days have been really, really volatile. And who knows what the... I would be hopeful but I don't know, what could happen to rest of the year.

Robert Spingarn - Credit Suisse

Absolutely, okay. Okay. And then sticking with accounting for a moment, could you walk through the royalty line and talk about what happened in electronic systems. And where these reversals occurred, just so we can understand a little bit better?

James F. Palmer - Corporate Vice President and Chief Financial Officer

Yes, if you were to look at the income statement, essentially the royalty receipts our part of segment operating margin. And so the segment operating margin rates or dollars and rate reflects the successful recovery or the settlement of those patent infringement areas. We then reverse it in total margin, and then add it back into other income. So it's... if you were to follow the income statement down, it's in segment, it's out of total and then back into other income.

Robert Spingarn - Credit Suisse

Okay. Okay, that's helpful. And then finally Ron or Wes, on tanker termination fee, any update there?

Wes Bush - President and Chief Operating Officer

No, Robert there is none. We are currently awaiting for further instructions from the Air force and also obviously are waiting for the next direction in terms of how the competition will be proceeding. But at this moment we have not received any specific instructions.

Robert Spingarn - Credit Suisse

Thank you.

Ronald D. Sugar - Chairman and Chief Executive Officer

Thanks Rob.

Operator

Your next question comes from the line of Ronald Epstein of Merrill Lynch. Please proceed.

Ronald Epstein - Merrill Lynch

Yes, good morning guys.

Wes Bush - President and Chief Operating Officer

Good morning.

James F. Palmer - Corporate Vice President and Chief Financial Officer

Good morning.

Wes Bush - President and Chief Operating Officer

How are you?

Ronald Epstein - Merrill Lynch

In your outlook for 2009, Jim, you mentioned that we could see some kind of meaningful upside to the margins in the ship business. What has to happen for that to happen? You kind of... or may the other way to ask is outside of looking in, opinion and what do we need to see, what are milestones, what can give us comfort so that can happen?

James F. Palmer - Corporate Vice President and Chief Financial Officer

Ron, it's simply performing against the contracts as we have today, the EACs and those contracts. Now LHD-8 for example, getting that ship completed is important, knock on wood. There maybe some other opportunities like we had in the third quarter if we get through trials successfully and that on LPDs essentially, the hurricane impact we think we have quantified that and reflected that into our EACs.

The opportunity essentially is to do better than what we have assumed in terms of helping our supplier recovery... recover from the impacts of the hurricane. Obviously we have a lot of experience in how to do that. And so we've had a dedicated group of folks helping them with those kinds of issues as well as thinking about what work that maybe it make sense for us to perform, so that we can minimize the total impact of the Hurricane Ike that the supplier experienced.

Ronald D. Sugar - Chairman and Chief Executive Officer

The other thing is that if I could add, this is Ron, keep in mind that only about half of that business in ship building segment is down on the Gulf. The other half is up at Newport [ph] news and part of this plan of course is to continue to perform outstanding on our carriers and our submarines. And that part of the business is going very well.

Ronald Epstein - Merrill Lynch

No I mean could we see an incremental like a 50 or 100 basis points, is that a reasonable thing to try to model?

Ronald D. Sugar - Chairman and Chief Executive Officer

50 or 100 basis points to what?

Ronald Epstein - Merrill Lynch

Operating margin?

Wes Bush - President and Chief Operating Officer

2.5%.

James F. Palmer - Corporate Vice President and Chief Financial Officer

2.5%, yes.

Ronald Epstein - Merrill Lynch

To go... I mean if you were to add that... I mean if you were to get... could you get towards 9%, I guess, that's what I am driving at?

James F. Palmer - Corporate Vice President and Chief Financial Officer

Let's say, I... as I said we'll give guidance for 2009 in our fourth quarter call. I really don't want to get ahead of that at this point. I think as I said we are going to see a meaningful improvement in ship building margin rates come 2009.

Ronald Epstein - Merrill Lynch

Okay and then I guess just one quick one for Ron. You mentioned how Rogers [ph] weathering sort of the big financial storm. What... from a much broader perspective. Tell me what impact do you think all the government involvement in the capital market will have on defense spending? In terms of just crowding out, I mean the pie is only so big?

Ronald D. Sugar - Chairman and Chief Executive Officer

Well, this is something we're spending a lot of time thinking about. And I know you are as well. As I said in my initial comments, I would take it from the point of view that the threat spectrum out there is not going to probably get easier and so the nation is going to have those threats. The new President is going to have a whole bunch of issues to deal with, but one of them he can't afford to allow happen is any real or perceived threat or attack on the nation. We are seeing an increasing wiliness on the part of the Congress to allow deficits to rise, that's obviously something a little bit different than we've seen in previous years.

We're seeing an increasing momentum to potential tax changes or tax increases, I think no matter who is elected upon looking for some of that I would think after stimulus is done. We really don't know where it's going to be, we know for '09 based upon the appropriated budget, we are solid. We understand where the longer-term contracts, we have multi-year contracts in some cases that are already underway. Clearly the pressures are going to increase in the out years and I really don't know yet how that's going to play. But again I keep coming back to the view that the threat is real and it ain't going away. And I think the key thing for us is to perform on the contracts that we have and make sure the contracts were positioned are, are the ones that are really going to be needed long-term. And that's why we are putting all of our energy. We are very comfortable with our portfolio of where those contracts stand relative to what we think the needs are going to be. And beyond that I think it's anybody's guess.

Ronald Epstein - Merrill Lynch

Right, thank you.

Operator

Your next question comes from the line of Doug Harned of Sanford Bernstein & Co.

Doug Harned - Sanford Bernstein & Co.

Good morning.

Ronald D. Sugar - Chairman and Chief Executive Officer

Hi, Dough, how are you?

Doug Harned - Sanford Bernstein & Co.

Good. I am interested on information and services. Back in February you talked about eventually long term getting into a 9% level margin. And as you look forward and you look at the three units within information and services, how do you see that taking place over time? Where do you expect the growth will be, where do you expect the margin improvements should come from?

Ronald D. Sugar - Chairman and Chief Executive Officer

Doug, as I think about that information and services, I think that is an appropriate long-term rate. If I look at the three segments or three pieces, I would have Mission Systems at the highest levels in terms of operating margin rate, the IT business essentially middle, and then the Technical Services business at the lower end below the average for the group in terms of margin rate. In terms of improvement, I think the biggest opportunity is in the information technology piece of the business.

Doug Harned - Sanford Bernstein & Co.

But overtime, if you have more growth in Technical Services, I'm just wondering about business next year as you lay out the different margins in those three units, is there more growth obviously in technical services that's going to limit your margin upside?

Ronald D. Sugar - Chairman and Chief Executive Officer

Yes, I don't think so. I think we are going to have proportionally our percentage wise a greater growth or have the opportunity to have greater growth in technical services. But it is still a small piece of the total and so it doesn't drive the margin... or the overall margin rate that greatly.

So again, when I look at both Mission Systems and IT, I see the potential for equal to or greater growth rate in terms of revenue in those two pieces as I do in technical services. So, I think the contribution, the relative contribution waiting will continue to be about what it is today.

Doug Harned - Sanford Bernstein & Co.

Okay, then on... then within there, Wes commented earlier that you are seeing the size of the state and local backlog go down in IT, but you did... you just did two small contracts in State of Oklahoma and State of Texas, are you thinking differently now about how you pursue those state and local contracts?

Wes Bush - President and Chief Operating Officer

Yes Doug, it is Wes. We are being very selective, we are looking at a variety of both financial criteria associated with the bid as well as I'm better understanding I think the customer expectations and their ability to contract in a way that makes sense for us. So, we have introduced a number of parameters that we're assessing in the state and local environment.

Doug Harned - Sanford Bernstein & Co.

So, you haven't ruled them out now; you're just looking at them differently?

Wes Bush - President and Chief Operating Officer

Yes, no, we have not ruled them out. There are some meaningful opportunities there, but we are being I would say substantially more selective today than we were even a year and a half ago.

James F. Palmer - Corporate Vice President and Chief Financial Officer

Yes Doug we have actually passed on a couple of fairly substantial opportunities that under a previous circumstance we might have well thought we couldn't resist. I would basically note them.

Doug Harned - Sanford Bernstein & Co.

Okay. Okay, great. Well thank you.

Ronald D. Sugar - Chairman and Chief Executive Officer

Thank you.

Operator

Your next question comes from the line of David Strauss of UBS. Please proceed.

David Strauss - UBS

Good morning, thank you.

Ronald D. Sugar - Chairman and Chief Executive Officer

Good morning David.

David Strauss - UBS

Your pension asset allocation you made the comment that it has shift away from equities. I think we had you at close to 50% based on your 10-K and the move to down 21% or 22% during October which seem to indicate still a pretty heavy weighting towards equities, do you have an updated allocation that you can provide?

James F. Palmer - Corporate Vice President and Chief Financial Officer

Yes. In terms of benchmark or policy, we at the end of last year had a 55% waiting to equities. The new benchmark is 35% and at the end of September we were little bit over 25% in equities.

David Strauss - UBS

Okay. And what about the fixed income versus other?

James F. Palmer - Corporate Vice President and Chief Financial Officer

Essentially the move in the benchmark or the policy from 55 to 35, we took 10 percentage points and added it to alternatives, and 10 percentage points and added it to fixed income. So from a policy perspective; today it's 35% equities divided between domestic and international, 25% in alternatives, and 40% in fixed income.

David Strauss - UBS

Okay. Ron, could you spend a second and maybe talk about how Northrop is looking at the smaller satellite opportunity, what I guess is referred to is ORS and what exactly the company is doing in that area?

Ronald D. Sugar - Chairman and Chief Executive Officer

Well, obviously this is something, we have continued to track in. We have not been a major supplier of small satellites over the years, David. Revenues have not been the same as they've been for some of our larger satellites. We do look at some of these satellites; we do look at ways that we can take off the shelf payloads, put them together, we have a couple of things where we're thinking about now.

I don't think we are in a position to project any significant targets or awards in that area at the moment. But it is something we will see continuing. There has been in my experience in this satellite business and it expands four decades, I am sorry to say, has always been a almost a dichotomy of view between large efficient satellites and small cheaper, faster, better satellites that goes back and forth in cycles. And it usually goes with what the most recent area of short coming was.

Today we are seeing some significant concerns about large satellite programs, I think the Doug [ph] Group in the Pentagon are deciding not to proceed at the moment with TSAT. Part of that issue has to do with the submission requirements, part of that has to do with the concern about how large it is.

On the other hand, in other venues, in military and intelligence world, you do see large satellite programs. So, I think we are going to see a mix over time. I think the proponents of revenues are still going to be with the larger satellite programs. And those are the franchise programs.

David Strauss - UBS

That's great. And one last from me for Wes, the Green Labor situation, there was so much of a problem on LHD 8, can you kind of address where you are there?

Wes Bush - President and Chief Operating Officer

Yes, it continues to improve. We've instituted a number of activities in the Gulf to address training, there's been a long lot of the application of less on LHD 8 to the other activities we have under way in the Gulf. We continue to look for experienced new hires but I would say overall our labor situation in the Gulf has stabilized. And we feel very good about the quality of the capability of labor force there.

David Strauss - UBS

Great. Thanks guys.

Wes Bush - President and Chief Operating Officer

Thank you, David.

Operator

Your next question comes from the line of Heidi Wood of Morgan Stanley. Please proceed.

Heidi Wood - Morgan Stanley

Good morning, nice quarter guys.

Ronald D. Sugar - Chairman and Chief Executive Officer

Thank you Heidi.

Wes Bush - President and Chief Operating Officer

Thanks Heidi.

Heidi Wood - Morgan Stanley

Ron, I wanted to just ask you a little about the outlook in 2009. Both candidates have been talking about it looks likes in the next administration, both sides are going to take a focus on cost growth within defense program, can you give us a sense about what steps you're taking to mitigate cost growth ahead of time so that when they turn to you and doing end up review, you come out strong?

Ronald D. Sugar - Chairman and Chief Executive Officer

That's an important question and it's a broad one. Obviously for as long as I have been in the business and I think everyone else procurement reform, cost growth have been the fundamental issues. It's just been the nature of the business of buying large weapon systems.

I think both candidates are going to take a fresh look at it. A lot will depend up on who they put in place in their national security teams and their defense teams. We do believe that there might be some initial pressure towards changing contracting types. But the thing with changing contracting types is that that's on a go forward basis. I think what we would have to do Heidi is be prepared to bid the programs appropriately for the contract type that's required.

So, for example there is more pressure on fixed priced contracting. I think speaking for Northrop we're going to be much more careful in terms how we would approach that. From risk management standpoint, I would dare to say most of the other companies would be as well. We've all been through the cycle about 15-20 years ago, where there was enormous pressure to do that, and that did not work out well either for the industry or frankly for the Pentagon because a lot of programs got cancelled.

One of the things we are doing internally and one of the things that Wes is focusing on very, very intensely is the execution of the programs we have, making sure that we're driving on technical performance, scheduled performance, and working to achieve the potential of the margins that are available to us on those programs as we negotiate the contracts.

And then going forward of course as we mentioned here a couple of times in the call, we are taking out a much more careful look at the structure of the contracts going forward. That contracts can beat good people nine times out of ten, we want good contracts.

Heidi Wood - Morgan Stanley

Great, thanks. That's very helpful. And secondly as a follow-up, can you flesh out a little bit, how does 2009 sales look if we do see a material step down in new program awards just again because of this budget tightening and we're already seeing with ARH and TSAT and others.

Ronald D. Sugar - Chairman and Chief Executive Officer

Well Heidi first of all, the way our business works as you know with our record backlog, that really does define a good portioning and an enormous portion of the estimated sales revenues for next year.

Secondly, majority of that is actually funded as a result of the Defense Appropriation Bill for 2009. And so... and as Jim had indicated in his... at the end of his remarks, we do see growth in 2009 and we'll quantify that obviously in the fourth quarter call.

So at this point in time, if I take a look at our portfolio of programs, there are always potential programs that could be cancelled midyear. We don't see a lot of at the moment. And frankly, the programs that were involved were pretty well fully funded as part of the '09 budget.

Heidi Wood - Morgan Stanley

I do know that Ron which is why I was hoping you might give us a percentage so that we could again, know that how much of your revenues are ahead or ultra rock solid, if they stay kind of 80% to 90%?

James F. Palmer - Corporate Vice President and Chief Financial Officer

HeidiI'd say that's about right. Maybe as much as 90%. The rock solid, you hate to say that word because you never know what will happen. But historically, very, very solid funded backlog, funded programs are budgeted for the fiscal year. And I'd say certainly in high 80s perhaps, as much as 90%.

Heidi Wood - Morgan Stanley

Great, thanks very much.

Ronald D. Sugar - Chairman and Chief Executive Officer

Thank you, Heidi.

Operator

Your next question comes from the line of Cai von Rumohr of Cowen & Company. Please proceed.

Cai von Rumohr - Cowen & Company

Thank you. Good quarter.

Ronald D. Sugar - Chairman and Chief Executive Officer

Thanks.

Cai von Rumohr - Cowen & Company

Could we return to shipbuilding. You mentioned $27 million of kind of charges for Ike and Gustav, $34 million plus, and the $36 million risks adjusted, is the 27 included in the 36 or are those separate. So is the net impact $29 million negative?

James F. Palmer - Corporate Vice President and Chief Financial Officer

The net impact is the 29 number.

Cai von Rumohr - Cowen & Company

Okay. And then, if it is the 29 number, if we add it back, and I understand it's not totally right, because some of the risk mitigation reflected on a period. I would imply a margin in shipbuilding of about 10%. Was there anything else positive in there to get us to that kind of a number, or was a lot of this risk mitigation applicable to the current period revenues?

James F. Palmer - Corporate Vice President and Chief Financial Officer

Well, you did pretty good math Cai. And yes, if you make those kind of adjustments you will get through that kind of number. There obviously were some strong performance in other programs as well, none of which I would characterize as unusual or exceedingly large, if they would... if they were we would have talked about it. So there were some programs in shipbuilding that had good strong performance in the quarter. And it goes with the comments that Ron and Wes have made about our attention to shipbuilding and the focus we all have is on how do we improve the Gulf Coast but there is parts of the shipbuilding enterprise that is doing very, very well.

Cai von Rumohr - Cowen & Company

Thanks. And then if we could kind of return to pension, you kind of mentioned that it's basically $4 million for each one point in performance.

James F. Palmer - Corporate Vice President and Chief Financial Officer

No, let me. Make sure we get the numbers right. For every 100 basis points change in the investment return, pension expense would increase or decrease by $40 million.

Cai von Rumohr - Cowen & Company

I guess the question is, is that linear or if in fact your $20 million to $21 million under water, do you basically go outside of the quarter so that number begins to escalate?

James F. Palmer - Corporate Vice President and Chief Financial Officer

No, not true. For financial accounting for FAS, it is essentially linear after our 10% negative... 10% assumption. So the FAS number is essentially linear, that 100 basis points is $40 million after the breakpoint, then CAS starts moving in concert, actually moving greater than FAS, and so the net difference above the break point starts coming down.

Cai von Rumohr - Cowen & Company

Okay, that very helpful. And then assuming you are in fact 20% to 21% underwater which is... begins to looks... look like will be there or greater, what are your initial thoughts about how much you might contribute to the pension plan in the fourth quarter or next year? How do you --

James F. Palmer - Corporate Vice President and Chief Financial Officer

We... I am sorry, go ahead.

Cai von Rumohr - Cowen & Company

How do you plan... how do you think about... how do you approach that problem?

James F. Palmer - Corporate Vice President and Chief Financial Officer

Well we start with the cash... the strong cash flow of the company, and we think about where the actual returns may come out, and where the discount rate may come out, all of which will be factors or considerations as we think about how much we may want to put in from a voluntary perspective into the plan here in the fourth quarter or maybe even early in 2009.

Cai von Rumohr - Cowen & Company

Okay. And the last one on pension, you mentioned year-over-year swing of $415 million from I guess $165 million plus to $250 million minus and yet if FAS goes to... goes... if that would imply that FAS goes to $665 million implying that CAS has to go down to around $415 million to 450, is that in fact what you're actually saying if you close --

James F. Palmer - Corporate Vice President and Chief Financial Officer

I think you just may have the numbers backwards. Today, 2008, we have a essentially net FAS, CAS income of $250 million.

Cai von Rumohr - Cowen & Company

Correct.

James F. Palmer - Corporate Vice President and Chief Financial Officer

At 10%... minus 10% and 7%, it goes to an expense of about $165 million, that's the $415 million, the net change.

Cai von Rumohr - Cowen & Company

Okay. And then --

James F. Palmer - Corporate Vice President and Chief Financial Officer

And that $415 million is essentially FAS going up by $465 million and CAS going up by $50 million to get to get to that $415 million net.

Cai von Rumohr - Cowen & Company

Got it. I got it. Thank you.

James F. Palmer - Corporate Vice President and Chief Financial Officer

I guess the other think we think you all recognize, but I just feel like I have to mention it. As you know we use the actual market value of our planned assets at the end of the year for determining our pension expense for next year. Others have a smooth effect. Economically the results were exactly the same. It's only the timing of when you recognize those economic results. We are recognizing them currently; others are deferring them into future years. My estimate is that if we were using a method similar to others that $415 million change year-over-year about 75% of it would have been deferred.

Cai von Rumohr - Cowen & Company

Thanks a lot. Thank you very much.

Ronald D. Sugar - Chairman and Chief Executive Officer

Thanks Cai.

Operator

Your final question comes from the line of Carter Copland of Barclays Capital. Please proceed.

James F. Palmer - Corporate Vice President and Chief Financial Officer

Hey Carter, how are you doing?

Carter Copland - Barclays Capital

I'm good guys. Actually all of my questions have been answered. Thanks, good quarter.

James F. Palmer - Corporate Vice President and Chief Financial Officer

All right, thank you. I like those calls.

Wes Bush - President and Chief Operating Officer

Thank you.

Operator

And there are no further questions at this time. I'd like to turn the call back to Mr. Gaston Kent for closing remarks.

Ronald D. Sugar - Chairman and Chief Executive Officer

Okay, this is Ron. This closes the call and I want to thank everybody for attending strong quarter. We really appreciate your continued interest and we look forward to talking to you at the end of the fourth quarter call.

Operator

Thank you for your participation in today's conference. This concludes the presentation, you may now disconnect. Good day. .

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Source: Northrop Grumman Corp. Q3 2008 Earnings Conference Call Transcript
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