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Northrup Grumman Corporation (NYSE:NOC)

Q4 2008 Earnings Call

February 3, 2009 10:00 am ET

Executives

Gaston Kent – Vice President Investor Relations

Ronald D. Sugar – Chairman of the Board & Chief Executive Officer

Wesley G. Bush – President & Chief Operating Officer

James F. Palmer – Chief Financial Officer & Corporate Vice President

Analysts

Myles Walton – Oppenheimer & Co.

Cai von Rumohr – Cowen & Company

Joseph Nadol – J. P. Morgan

Joseph Campbell – Barclays Captial

Ronald Epstein – BAS-ML

Robert Springarn – Credit Suisse

Richard Safran – Goldman Sachs

David Strauss – UBS

Troy Lahr – Stifel Nicolaus & Company

Operator

Good day ladies and gentlemen and welcome to the Northrup Grumman fourth quarter earnings conference call. My name is [Onika] and I will be your operator for today. At this time all participants are in listen only mode. We will have a question and answer portion at the conclusion of the presentation. (Operator Instructions) As a reminder, this conference call is being recorded for replay purposes. At this time I would now like to turn the call over to Mr. Gaston Kent, Vice President of Investor Relations.

Gaston Kent

Welcome to our fourth 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 www.NorthrupGrumman.com. Before we start, please understand that matters discussed on today’s call constitute forward-looking statements pursuant to Safe Harbor provisions of federal securities laws.

Forward-looking statements involve risks and uncertainties which are detailed in today’s press release and our SEC filings and may cause actual company results to differ materially. During the call we’ll discuss fourth quarter and full year results and 2009 guidance. We will refer to non-GAAP measures which are defined and reconciled in our earnings release and supporting materials which are posted on our website.

On January 7th, we announced a reorganization that impacts several of our businesses. The 2009 guidance we present today will reflect our new organization. For reporting purposes, the reorganization will be reflected in our first quarter 2009 results.

On the call today are our Chairman and CEO Ron Sugar, our President and COO Wes Bush and our Chief Financial Officer Jim Palmer. Also with us today is Paul Gregory, Paul is my replacement as Vice President of Investor Relations and will be your primary contact at Northrup Grumman as soon as I push the off button on this call. He was previously the Chief Financial Officer of our space technology sector.

If you’d now please go to Slide Three, I’d like to turn the call over to Ron.

Ronald D. Sugar

Thanks for joining us to discuss our fourth quarter and full year results. Operationally we had a very strong finish to the year. We achieved record sales, record cash from operations and record free cash flow. Sales increased 6% to nearly $34 billion making us now the nation’s second largest defense contractor.

We had a tremendous year for cash generation. Cash from operations and free cash flow exceeded the upper end of our prior guidance range even after $200 million for discretionary pre-funding of our pension plans. Our adjusted EPS from continuing operations totaled $5.21 which also exceeded the upper end of our prior guidance. This excludes the previously announced goodwill impairment charge which was driven by the dramatic declines in market multiples. This non-cash charge did not affect our operations. Jim will report on this in more detail shortly.

The yearend number I’m most pleased to report is total backlog. We begin 2009 with a record $78 billion backlog, a 23% increase over last year’s ending backlog. In 2008 we captured a record $48 billion in new business which comprises of substantial competitive wins and large follow on awards in our core franchise programs. This represents a very healthy 143% book to build ratio. Our backlog growth demonstrates two major strengths, first our company continues to become more competitive. We had substantial competitive wins across our business portfolio resulting from our leading edge technologies and innovative solutions for our customers.

For example, we extended our winning streak in the unmanned aerial vehicle space by winning the BAMS program which also demonstrates that our internal R&D investments are really paying off. Second, we are leveraging our portfolio of large long term franchise programs that will provide profitable revenue for years to come. Ship building backlog is up $9 billion with the $5.1 billion contract for the Gerald R. Ford Carrier and the $5.6 billion contract for Block-3 Virginia Class submarines.

Under the new contract for submarines we and our partner General Dynamics will begin producing two boats per year in 2011. This is a strong testament to the success of our industry partnership and its record of driving down the Virginia Class costs through teamwork with the United States Navy. Our aerospace business also posted a multibillion dollar backlog increase with key restricted awards, follow ons to franchise programs like the award of 24 F18 ship sets for Australia and the US Navy and new B2 Bomber upgrades worth about $500 million.

The strength of our 2008 financial results allowed us to continue our shareholder value enhancing actions. We increased our divided by 8%, the fifth consecutive annual increase and a doubling of the dividend since 2003. We also repurchased $21.4 million shares of our common stock during the year and we have $945 million remaining on our share repurchase authorization. Along with executing our balanced cash deployment strategy, we continue to maintain a strong balance sheet.

Even with the goodwill impairment charge and decline in pension plan assets, we ended 2008 with a net debt to total capital ratio of 15% and we continue to enjoy the highest credit rating in the company’s history. In this economic environment, we intend to maintain a strong balance sheet and significant liquidity. We see continuing solid performance for the company next year. For 2009 earnings, we are focusing on performance as measured by pension adjusted earnings. On that basis, we see year-over-year earnings per share growth of between 9% and 15%. The use of pension adjusted EPS estimates, eliminates the distortive affect pension accounting has when comparing our 2008 results with our outlook for 2009.

Now, turning to the defense spending environment, President Obama has made strong choices for his national security team. Secretary Gates provides critical continuity with his understanding of the many complex issues facing DOD. Clearly, the new administration well understands that the threat environment we have out there is not diminishing. There is also universal consensus that our service men and women deserve the highest quality weapons systems and security solutions.

Our government’s challenge is to balance persistent critical national security needs with the very real economic crisis that is putting unprecedented pressure on government spending. In his recent testimony before Congress, Secretary Gates stated that the DOD must make tough choices. The President’s team will make his priorities known with the release of the 2010 budget and the quadrennial defense review. We will know more in the spring.

However, we expect that the majority of our programs at Northrup Grumman will be supported in the 2010 budget process and we believe going forward our portfolio is sharply aligned with both the traditional and emerging priorities. Program execution, innovative solutions and value to the war fighter will be the key competitive differentiators for Northrup Grumman.

In addition to the formidable traditional threats our nation faces we must now respond to new unprecedented non-traditional threats. To paraphrase the Director of National Intelligence, cyber attack may pose the 21st century’s most serious economic and national security challenge. Hostile penetrations of the cyber systems of the United States are wide spread, successful and growing. The government will spend substantially to address these risks. We believe that this will be a priority mission under the new administration and Northrup Grumman is a leader in this area.

We are currently supplying cyber security systems to many agencies and we are integrating those capabilities to address the cyber security challenge. Organization structure should follow strategy and by recently combining our mission systems and information technology business sectors we have concentrated the majority of our leading capabilities in to a single entity, our new information system sector led by Linda Mills.

The air refueling tanker will be another priority of the new administration. We are very encouraged by the administration’s commitment to our rapid process to replace our aging air refueling tankers. Our nation and our military service men and women urgently need this new tanker. We are fully committed to this program. We won this competition once and we intend to win it again.

We are proactively addressing the increasingly competitive environment for our products and services. In January we announced a reorganization of our seven segments in to five. These organizational actions are aimed at strengthening our alignment with customers, improving our ability to execute on our programs and win new business and enhancing our company’s cost competitiveness.

My number one priority for Northrup Grumman is program execution. While there is more work to do, we are making solid progress. Wes will update you on program execution during his comments shortly. In summary, we had a strong operational finish to 2008. We are focused on performance improvement and competitive positioning. We are financially solid and making the necessary investments to capture new programs. We are positioning the company for the future.

Now, I’ll turn the call over to Wes for an additional discussion on Northrup Grumman’s operations.

Wesley G. Bush

My comments today are outlined on Slide Four. This quarter I’ll talk about our business capture efforts, highlight some of the programs we’re pursuing and finish with an update on our program execution. The tremendous effort we put in to our business capture processes is succeeding as demonstrated by our growth in backlog.

Just as important as that level of backlog is the quality of the contracts that we’re entering in to with our customers through an adherence to more stringent bid criteria. We’re being more selective, our total backlog is growing and the quality of that backlog is improving. As we continue to have a very high quality robust multibillion pipeline of opportunities.

In addition to tanker, we’re pursuing the scalable agile beam radar for the F16, CANES or the Consolidated Afloat Networks and Enterprise System program, the airborne ISR programs called EPX and ACS, the TSAT program and the GPS OCX program. We also continue to have substantial opportunities in the restricted area. As you can see with the expansion of our backlog, we are becoming more competitive as we address this robust pipeline.

Turning now to our programs, my key operating priority is superior execution across all of our 20,000 programs. I’ll focus my remarks this morning on the progress we’re making in retiring risk on our key watch list programs. On Block-60 we successfully delivered on schedule the Falcon Edge software increment in the fourth quarter representing a substantial risk retirement milestone. There will be one subsequent key software update to complete the Falcon Edge Electronic Warfare capability later this year.

We continue to perform within our EAC with the primary remaining risk mitigation milestone being final contract close out. In last quarter’s Wedgetail update, we were waiting for the customer go ahead again, type acceptance testing. In the fourth quarter we reached a customer agreement that allowed us to start TAT&E. The ground testing phase began in December and flight tests are scheduled to begin this quarter. Successful completion of these tests will represent another major risk mitigation milestone.

On the New York City wireless program, we continue to make good progress in building out the network. On January 13th we achieved a key milestone, conditional acceptance and we now have 95% coverage across the city. The system is up and running and providing service to the customer. We expect to achieve full system acceptance in the first half of this year and we’re operating within our EAC.

The San Diego contract continues to perform to its plan as well. Future profitability on this program will depend on the level of revenue from future county service demands. On the Virginia IT program, we’ve made solid progress towards completing the transformation phase of the Commonwealth’s infrastructure transition to the new common IT environment. The focus item on this program will be the timeline for transitioning the remaining agencies over to this new environment.

Our approach to state and local opportunities continues to be very disciplined. We are not bidding on programs unless they meet our stringent criteria. This more selective approach has led to declining revenue from state and local IT programs and this drove the slower growth rate for our IT sector in 2008.

I’m also pleased to report that our ship building team continues to make solid progress LHD 8 achieve its fourth quarter milestone the peer side integrated propulsion test and we began builders trials ahead of schedule with an initial trial in December. In that trial we demonstrated all the primary capabilities with the exception of the full power and endurance runs for the propulsion systems. These tests are planned to be performed with the final builders trial that is scheduled for this quarter.

Acceptance trials will follow shortly thereafter. We’re on track to deliver the LHD 8 in the second quarter of 2009. We continue to perform well against the EAC and we were able to recover some reserve in the fourth quarter as we retired the risk. So, in summary, we continue to make good progress on these programs as this quarter’s results demonstrate.

With that, I’ll turn the call over to John.

James F. Palmer

My comments begin with Slide Five, I’ll discuss the fourth quarter and 2008 results, the goodwill impairment charge, update you on pension performance and then conclude with a discussion on our 2009 guidance. Our operating results for the fourth quarter were very strong as Ron has mentioned. As you know, I place a lot of emphasis on the importance of cash flow so I’m particularly pleased with our cash from operations and free cash flow results for the year.

This year’s performance represents a new income conversion of 135% before the goodwill impairment charge. I’m very proud of what our team accomplished in 2008. Due to the strong year end collections, we reduced trade working capital even while increasing sales by 6%. We exceeded the high end of our guidance range by a substantial amount even after considering the $200 million of discretionary pension pre-funding.

This quarter’s large goodwill impairment charge was driven by the dramatic decline in the equity markets. This caused a sharp decline in market multiples in our industry and for Northrup as well. As many of you are aware, the annual testing for goodwill impairment is a process that compares the fair value of each business to its recorded book value. We determined the fair value of each business based on its discounted cash flow forecast.

Cash flows for each of the businesses change from year-to-year but the calculation is really dominated by the terminal year market multiple. Had market multiples on November 30, 2008 been at the same level that they were the prior year, November 2007, the goodwill for ship building and space technology would not have been impaired.

Moving on to pension on Slide Six, during last quarter’s call we gave you some sensitivities that we thought would be useful to model our 2009 pension costs. That model was based on a 7% discount rate and a -10% return. We also noted that at the time of our third quarter call in October, our planned investment returns was about -20%. Now, what happened?

Well, interest rates held fairly constant to that 7% level until the last couple of weeks of the year when they declined substantially, so the discount rate applies to year end pension liabilities turned out to be 6.25% which is lower than the model we provided to you. However, our investment returns improved in the fourth quarter. We ended the year with a negative return slightly more than -16% which is very strong relative performance.

Earlier in the year we decided to underweight equities, a decision that really paid off and reduced our investment losses from what they would have been by about $1.7 billion. Based on our actual plan returns and our expected CAS expense, we estimate that our net FAS/CAS pension adjustment in 2009 will be an expense of approximately $335 million or about $0.65 on a per share basis. Our underlying assumptions are an 8.5% long term rate of return and a discount rate of 6.25%.

We also updated some of the underlying pension plan actuarial assumptions to reflect the current economic situation. The sensitivities we provided last quarter are before those changes in actuarial assumptions. I would also remind you that we absorbed the full 2008 asset valuation impact in the calculation of 2009 pension expense rather than smoothing the impact over several years as many of our major peers do.

On a cash basis, our minimum pension funding requirements for 2009 is about $130 million. Our current plans call for an additional $500 million pension pre-funding in 2009. At the end of 2007, the funded status of our plan stood at about 104% and at the end of 2008 the funded status was 84%. This change in funded status results in a $2.8 billion reduction in shareholders’ equity on an after tax basis.

Now, let’s move on to guidance on Slide Seven, our guidance for 2009 GAAP earnings per share is $4.50 to $4.75 versus the 2008 adjusted EPS excluding the goodwill impairment charge of $5.21. A significant driver of the year-over-year variance is the change in net pension adjustment from income of $263 million in 2008 to an expense of approximately $335 million in 2009. This nearly $600 million swing translates to about $1.20 on a per share basis.

Negative pension plan returns and our pension accounting method caused a largest distortion in our GAAP earnings comparison and as many of you know, under federal government cost accounting rules we are reimbursed over time for our pension costs through our contracts so it is really the cost accounting expense or CAS, pension expense that drives our margin rates along with ERISA, our pension related cash flows. For both of these reasons it makes much more sense to use pension adjusted EPS to understand Northrup Grumman’s underlying business trends.

So on a pension adjusted basis, our earnings per share guidance for 2009 is $5.15 to $5.40 which represents growth of 9% to 15% over the 2008 pension adjusted EPS. The year-over-year improvement reflects a sales increase to approximately $34.5 billion, a higher pension adjusted operating income rate and a lower share count. These are partially offset by higher corporate unallocated expense and a reduction in other income due to the non-recurring nature of the patient infringement settlements in 2008.

For 2009, we do expect higher sales but they will be offset somewhat by lower revenues in missiles, ship building and state and local IT which will, as I said, partially offset the growth in other businesses. We provided the same adjusted comparison for segment operating margin rate and operating margin rate so on an adjusted basis segment OM rate improves to the low to mid 9% range from 8.6%. So, we do expect segment margin rate expansion in 2009 which will be primarily driven by higher ship building margins.

Operating margin rate on a pension adjusted basis improves to the mid 8% range for 2009 from 7.9% in 2008. We expect GAAP reported margin in the mid 7% range and our expected tax rate is approximately 34%. Turning to cash generation, we expect another strong year of cash generation. Before any pre-funding of the plans we expect cash from operations in the range of $2.7 to $3.2 billion and free cash flow of $1.9 to $2.4 billion. For 2009 cash flows again will be weighted towards the second half of the year.

During 2009 we plan to continue our balanced cash deployment strategy by investing in the business through disciplined capital expenditures as well as potential acquisitions. Managing the company’s liabilities including voluntary pension contributions will be an area of focus as well as returning cash to shareholders through dividends and share repurchases. As Ron mentioned, we have $945 million remaining on our current repurchase authorization.

As many of you know, we have returned substantial cash to our shareholders. Over the last three years we have spent more than $3.5 billion to repurchase 48 million plus shares and we have doubled our dividend since 2003. So, in summary, putting aside the market multiple driven goodwill impairment charge, we had a very strong quarter and we ended the year with strong results and a solid foundation going in to 2009.

With that we’re ready for some questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Myles Walton – Oppenheimer & Co.

Myles Walton – Oppenheimer & Co.

Maybe Jim, I was wondering on the goodwill impairment if we can focus on that just for a second, there are two variables one is the market multiple and the other is future outlook for cash flows. You commented that if the November market multiple was the same as last year you wouldn’t have taken a charge but could you elaborate of there have been changes in your forecast for the future cash flows on a negative basis for the businesses that you took the charge on and what that might mean for the 2012 targets?

James F. Palmer

Myles, as I said there are always year-over-year changes in cash flows. The key driver as I said on the call this morning was market multiples. Again, the predominance of cash flow value is determined from the discounted cash flows is market multiple driven. There are some lower cash flows coming out of the businesses as I look at them today but again, the predominate driver is the terminal value market multiple applied to that terminal year and the five years of cash flows.

Myles Walton – Oppenheimer & Co.

So should we read anything in to the charge with respect to your 2012 targets?

James F. Palmer

No, I don’t think so.

Myles Walton – Oppenheimer & Co.

Then maybe another follow up for you Jim, on the pension expense how much is flowing through the segments in terms of CAS in 2009 as maybe a headwind to margins? And also, if you could comment on what FAS and CAS would look like in 2010 if everything kind of hit the plan.

James F. Palmer

CAS is increased in 2009 over 2008 about a 10% level. Those kind of rough numbers. On a go forward basis assuming we hit our 8.5% long term rate of return I would expect to see a small increase in FAS expense or a general increase or a consistent increase in CAS expense as we go through time. Clearly, the cost accounting standards have a much greater smoothing affect associated with them so anyone that had negative pension returns in 2008 will have higher CAS expense as we go through time over the next few years.

Myles Walton – Oppenheimer & Co.

Then Ron maybe a follow up for you with respect to capital deployment, could you comment on given your strong balance sheet and relatively no interest income coming in from any cash balances, the priority with respect to M&A has that ticked up at all or are you still more favored towards dividends or share repurchases at this point?

Ronald D. Sugar

Myles, I don’t see any change in our stance here. We’ve tried to maintain a balanced look here. We’ve done some very small M&A because of some extraordinary opportunities we’ve seen. We certainly will continue to look for those opportunities in the future but as we look at the balancing needs of share repurchase, pension pre-funding, some debt retirement, we’re going to continue to kind of balance it as we go.

The 15% debt to total capital ratio is a good number. That’s not necessarily a target for us but we want to maintain a high degree of liquidity and flexibility in the next year or two just because I think, as everyone else, we want to make sure we’re adequately matched for whatever might come at us in the economy.

Operator

Your next question comes from Cai von Rumohr – Cowen & Company.

Cai von Rumohr – Cowen & Company

Could you give us some more color Jim, you mentioned actuarial assumptions, briefly what were they and the impact on your FAS/CAS for 2009?

James F. Palmer

The actuarial assumptions Cai are much more driven to the FAS side than to the cost accounting side. The principal changes as I mentioned were tied economic assumptions. We have a cash balance feature to our pension plan and that cash balance feature has an interest rate applied to the balance that is credited to individual accounts and obviously with lower earning rates we thought it made sense to reflect what we are going to see as actual credits for the cash balance plan in the near term and then trending back up to more historical levels.

We also expect that for a sharp period of time we’re going to see a delay in early retirements given economic situations so we reflected a slide in the period of time we expect to see those early retirements. Then the final assumption really deal with salary scale and again, given the economic situation we thought there is going to be a little bit of delay in the growth in salary scale as compared to what we had seen in the past.

Those assumptions essentially tended to somewhat mitigate the change in the discount rate from the 7% level that we had assumed at the end of the third quarter to the 6.25% that we ended up at the end of the year.

Cai von Rumohr – Cowen & Company

Last one, could you give us some color no where we expect royalty, general corporate and other income in 2009?

James F. Palmer

We had a very successful year in 2008 in resolving a number of the patient infringement suits where those are largely behind us in this point of time so I don’t expect any kind of significant level of royalty income. We traditionally have a few million a year but it is really just that, on a normal run rate a few million a year.

The other expense piece of the other net again is largely influenced by the non-qualified benefits that we have and to a certain extent that is market driven. From a planning perspective I am looking at an additional cost there for this year.

Operator

Your next question comes from Joseph Nadol – J. P. Morgan.

Joseph Nadol – J. P. Morgan

On the sales outlook, I thought the numbers were a little bit light and you were looking for a little bit less than 2% sales growth for 2009 and I guess taking a step back you have a $42 billion target out there for 2012 so we’re looking at lower than 2% growth in 2009 and then that would need to step up to 7% [cager] the subsequent three years to get to that level. I know you’re excited about your backlog and the outlook but obviously there’s uncertainty in the budget. What would you say Ron on how you feel about that outlook right now?

James F. Palmer

Let me take the near term piece of it and then I’ll turn it over to Ron for the longer term piece. As I mentioned in my comments, we do see sales growth to the $34.5 million level, I can expect that some of you maybe thought that the sale growth could be higher. There are, as I mentioned in my prepared comments three areas where there are some significant declines in revenues on a year-over-year basis between ’08 and ’09. They are in the ships area where we have essentially a dip in activity as we complete the Bush and then transition to the new Ford carrier as well as completing the RCOH on Vincent and then transitioning to the Roosevelt.

Likewise, we see a decline in missiles resulting from basically a completion of activity around the IPIP program and then finally as both Wes and I commented, lower revenues in the state and local arena. Those three areas are probably about a $800 million decline on year-over-year basis.

Ronald D. Sugar

Let me just tag on to that in terms of the long term. A year ago we laid out what we thought ought to be reasonable targets to address given our then understanding of the defense market, the economic world that we are in and frankly also the pension performance market that we thought we might be able to continue to have. Clearly, we have a different environment now however, I will tell you that our view of the opportunities for the long term margin rates that we think we can achieve in this business has not changed.

Joseph Nadol – J. P. Morgan

How about the top line Ron? It sounds like you’re maybe coming off that number but do you expect the top line growth to accelerate I guess from 2% to more like a mid single digit number or is that something you don’t want to address right now?

Ronald D. Sugar

I can’t address beyond the guidance we’ve given for ’09. Clearly we want to see how the 2012 budget and the QDR layout and the 2011 budget. I think that frankly will be a more important determiner of top line. At this point in time we’re reasonably comfortable that our program set is solid but like everybody else we’re going to wait and see how the President’s budget actually lays out for 2010 and beyond.

Joseph Nadol – J. P. Morgan

Then just on the same lines, and Jim thanks for the color on the sales but, along the same lines just looking at the margins, just the company segment margin overall coming in to 2008 we were looking at mid to high 9s and then obviously there was the LHD 8 issue and a number of other pluses and minuses but your base line expectation for the business excluding all that stuff was mid to high 9s. Now, we’re coming in to 2009 looking for low to mid 9s. How would you characterize the difference in the outlook one year ago today going in to 2008 versus today just given the mix of businesses and frankly the lack of items that are affecting either one?

James F. Palmer

As I think about our forecast or guidance for this year it’s really based on what I see today. Clearly, there are always risk and opportunities, we intend to address those as we go through time. We’ll update you as those opportunities are realized and we mitigate the risk. I think as Ron said, our view of the long term margin opportunities for these businesses still holds, it really hasn’t changed so we are essentially confirming that long term opportunity view of margin rates.

In terms of year-over-year change, as Miles or Cai asked previously there is some growth in CAS, cost accounting, pension costs. As we looked forward we tried to reflect our view of the impact of those costs in to our expectations for margins in 2009 as well.

Joseph Nadol – J. P. Morgan

Let me slip one more in, the ship building margin outlook, you’re at 8%ish, you did better than that in the fourth quarter and I guess things look like they’re working their way up a little bit on performance but, certainly in terms of LHD 8. I’m wondering are you being conservative there because of that transition you talked about there in your sales outlook or is there something else going on?

James F. Palmer

That is a impact in 2009. Let me just comment a little bit on 2008 fourth quarter margins which were frankly strong at 9%. We did have some risk retirement on VCS, the submarine program Block-2 which contributed to earnings as well as Mike Petters and his team have really actively managed overhead throughout 2008 in anticipation of the dip in revenues in 2009 and so frankly we had some favorable performance on actual 2008 overheads versus what our expectations were, all of which were positive contributors to earnings in the fourth quarter.

Again, as I look forward in to 2009, I know we have the dip in revenues that has an impact on overhead absorption. I do see improvement, underlying improvement in the operations of the ship yards, all of which have been reflected in our guidance for margin rates for 2009.

Operator

Your next question comes from Joseph Campbell – Barclays Capital.

Joseph Campbell – Barclays Capital

Ron, could you talk philosophically and kind of managerially about what this reorganization that you announced earlier in the month really means and sort of what was behind it? Some of it looks like it was sort of integration that might have happened a long time ago when you bought [TRW] but maybe personalities or management wasn’t quite ready for the shift but others of them, I’m not quite sure what’s going on with some of these groupings and maybe you could just shed some light on that.

Ronald D. Sugar

Obviously over time all companies reorganize and as I mentioned in my initial comments, your structure needs to follow your strategy and as we look at becoming even more competitive and being able to more agilely deploy talent to different major programs both either capture them or execute on them, it struck Wes and me that the combinations of a couple of these units would be something we ought to go forward and do.

It creates some larger entities but they do have more critical mass. Let me just take the two key combinations which we’ve done. By putting our two aerospace businesses together, our aircraft and our space business which are by the way, largely collocated within a couple of miles of each other here in Southern California. We see an opportunity to very substantially improve the ability to move talent between the businesses, we see an opportunity to pursue the strategic initiatives involving the space and air continuum and strategic ISR.

We think between unmanned vehicles and space there’s going to be more trades between those. And frankly, also the ability to eliminate certain back office costs which we just don’t need to have here going forward. I think we are at the point, I think you made an observations about the maturity of the integration, we are at a point now where culturally and a people standpoint this makes sense and we can do this.

The other area which area which we are very excited about is the combination of our mission systems and our information technologies sector in to the new information systems sector under Linda Mills and this will also be about a $10 billion entity. This again is a structure following strategy. We found that over time the two businesses while we had made some efforts to partition where they went in fact did find themselves in the market place having to work together in a way which was awkward and we found that we could bring greater critical mass to our customers by actually realigning and putting this all under one common management, under one roof if you will.

Again, the opportunity for significant synergies, these two businesses are largely located in Northern Virginia, although they have multiple sites there and an opportunity in addition to agile deployment of people and talent and massing for major bids, the ability to take some costs out as well. This just seemed the right sort of things to do. I might also mention Joe that through the other sectors that are unaffected and also the corporation as a whole, we’re continuing to look at how to streamline to become more agile and more competitive. We think the environment demands it. Frankly, we’re getting ahead of it and we think it’s the right thing to do.

Joseph Campbell – Barclays Capital

Ron, just one other question and I don’t mean this in a mean spirited way in any way but Northrup is the only company that had these impairment charges. Is there something different about either the amount of goodwill or the growth rate for ships that somehow led Northrup to be unique in taking the big impairment? I mean, there was a ton of M&A but we haven’t seen anybody else do it and it just sort of strikes me that it is just sort of another example of Northrup being a little different?

Ronald D. Sugar

Let my buddy here Jim Palmer answer that question. I think he can give you a pretty concise answer.

James F. Palmer

A couple of observations Joe, we are not the only ones that have taken goodwill impairment charges. There are others in our industry, although smaller who have taken goodwill impairment charge, Harris for one example. Other observations, as we mentioned at our investor conference last year when we talked about goodwill and RONA and its impact on goodwill and its impact on RONA, our acquisitions largely were completed towards the end of the cycle defense industry acquisitions largely completed after the adoption of 142, the new standard which did not allow the amortization of goodwill that some of our other competitors who had purchased transactions amortized goodwill.

Some of them had pooling transactions if we go further back where there really wasn’t any goodwill associated or recorded with those transactions. We did end up with proportionately more goodwill than many of our competitors due to the timing of our acquisitions and we did not have the opportunity to amortize any of the goodwill, or much of the goodwill unlike our competitors. So those are two historical factors that are important and then as I mentioned it really is our view of market multiples for each of our businesses that drove the actual impairment charge this year.

Joseph Campbell – Barclays Capital

Just a follow up, with regard to the way that you measure yourself on RONA and the returns, do you think you were previously being sort of penalized relative to the industry benchmarks because of these things you’ve gone through or because you’ve now taken these charges will you for purposes of compensation and so on based on return type metrics adjust it back up as if you hadn’t written it off because of course if you right it up [inaudible].

James F. Palmer

Our intention on a go forward basis is to revise the base line for the RONA portion of our long term goal to reflect the lower base if you will so the bar will be increased as we go through time. RONA is just one of the two long term measures of our long term plan, the other is operating margin dollars accumulative over the three year period. There may be a benefit on one side, there’s a cost on the other.

Operator

Your next question comes from Ronald Epstein – BAS-ML.

Ronald Epstein – BAS-ML

Ron, just a follow up on some of your initial remarks, you mentioned the opportunity in cyber security, do you mind to elaborate on that? Potentially how big of a market is it and what do you guys bring to the space?

Ronald D. Sugar

Well, at this point in time Ron it’s hard to really quantify it for a lot of reasons, first of all it’s huge. A lot of it is something that is visible, a lot of it that may in fact not be visible. As we look at our understanding of where the Department of Defense and the Intelligence Agency are putting future money on their plans, we see an increasing part of it being in cyber security which relates to not only protection against cyber threats but also dealing with the broader issue of cyber warfare going forward.

So, certainly this is a multibillion dollar sort of opportunity at large. It has ramifications frankly for not just defense purposes but also for other civilian agencies that have to deal with security of their own networks so there is a lot of work to be done here. The company is remarkably positioned with the skills we bring in this area. This is an area we’ve been working on for a long time and have a very, very strong market position and we see this improving.

I’ll give you an example of one area where we’ve been able to expand this that we’ve been talking about and that is our acquisition of Essex. Essex was a company that was focused on this area and since our acquisition we have seen that business have a dramatic increase in demand for what they’re doing and I think that’s just representative of what we see. So, the short answer is I can’t give you a precise dollar number but I can tell you it’s billions and billions.

Ronald Epstein – BAS-ML

Then how do you think about – there’s also commercial contractors who work in that space, are they competitors, are they potential folks you could team up with, are they potential M&A candidates?

Ronald D. Sugar

I think more people we can team up with Ron. You think about where we would be addressing our attention would be largely to the defense and intelligence space, those markets which we understand extremely well and where we can partner with a commercial competitor to do that better, that’s great. In general, we do have some special and unique skills as a result of our deep understanding of intelligence and defense that many of the other commercial players do not have and frankly we are also not primarily interested in addressing the commercial market for our services, that is helping other companies with their internal security threats. So, I think more an opportunity for collaboration Ron than competition.

Ronald Epstein – BAS-ML

Then finally, when we think about the opportunity set in maybe the more near term, what could happen in say the next six to nine months, what is that laundry list of things we should keep an eye on?

Ronald D. Sugar

Well, I think Wes gave you a set of targets that we’re pursuing. I think we’ll look for the restart of tanker at some point although we don’t expect that will be a 2009 event. As Wes talked about, the F16 radar work could be significant. We have work on E2 that we might be able to bring in internationally, CANES, EPX, ACS, the TSAT competition is a big one for us and our partner Lockheed that should be able to get we think off the dime here later in the year and of course the down select process on GPS OCX. Those are kind of the trigger points we’re looking at and in addition a whole raft of follow ons of our franchise program work which would go in to our future backlog.

Operator

Your next question comes from Robert Springarn – Credit Suisse.

Robert Springarn – Credit Suisse

Could you talk a little bit about the nice changes we saw in unfunded backlog in the quarter particularly in space and I think in tech services as well?

Wesley G. Bush

Let me just say a few words across the board, much of that growth in unfunded backlog comes from our success in building on follow on activities to long standing programs that we have in the company. Ron talked a little bit about it for ships, space was similar, tech services has a little bit of that but when you combine that success in building on those franchise programs with the successes that we’ve had that I described on the competitive front, together those generated a record year of backlog growth for us.

So, it was really the combination of those two things, both competitive and the benefit of having large scale franchise programs that we can continue to build on.

Robert Springarn – Credit Suisse

Then in contrast to some commentary on the lighter aspects of your’09 revenue guidance perhaps in ships and a couple of other spots, ES looks real good, real strong there. Can you talk about that? Ron, can you talk about any major opportunities perhaps that can enhance any of the segments in this fiscal year?

Ronald D. Sugar

Well, obviously electronics went through a couple of years of flattening a few years ago and we put a real press along with Jim Pitts on improving our competitiveness there. They’ve been knocking the lights out in that area and they’ve been adding backlog and you can see that they’re sales are growing accordingly. As you know, it’s an extraordinarily well performing business with very good margins.

We see a few opportunities as we go through. We’ve outlined most of the individual ones already and we’ll just sort of watch and see. When we build a plan we have to make some assumptions about how funding gets metered out. We’re also not mindful of the fact that some of the programs that we have in our plans could have some stretches associated with them, others could potentially be accelerated and what we’ve given you here is guidance which reflects kind of our integrated view of how that will all play out for the year.

If it turns out that there are not stretches or slips or no reductions in funding then we could have some upsides. If we were to see a program or two significantly delayed or an award put off that could have an impact on the other side. But, I think the numbers we’ve guided to the $34.5 billion are about our best guess at this point in time.

Operator

Your next question comes from the line of Richard Safran – Goldman Sachs.

Richard Safran – Goldman Sachs

You mentioned substantial opportunities in the restricted area in your opening remarks and in 2008 good classified bookings so based on what opportunities you are watching and I’m assuming you’re doing some type of internal expected value calculation, can you comment directionally on what you think 2009 classified bookings might be like? I also ask this in the context of your comments pertaining to a more stringent bid criteria?

Ronald D. Sugar

Richard, I really can’t give you any more color on that for obvious reasons. I will emphasis Wes’ comments about more stringent bid criteria. It turns out in our restrictive business we often find that to be our business that gives us the greatest opportunities to bid the kind of ways we want to bid, it’ some of the other programs that we need to put additional attention on in terms of bid criteria. We’re going to use them across the whole spectrum of what we bid but I wouldn’t single out restricted as an example there.

Operator

Your next question comes from David Strauss – UBS.

David Strauss – UBS

Just to clarify on your EPS guidance, I think Ron you had talked about that on pension adjusted basis it implies high single digit low double digit kind of growth but just to be clear, if you adjust for the ship building charge last year it looks like flat to just slightly higher EPS growth. Is that correct?

James F. Palmer

David, the way I think about it is ’08 did have some unusual items in it. You can’t just take the first quarter shipping charge because we had some offsets or some reversals of that charge in the third and fourth quarter and we also had roughly $60 million of royalty or patent infringement settlements so when I net all that down, that is about a $200 million impact to segment margin rate. So, the way I think about it essentially is I have part of that operational improvement that is the absence of all of that net item and then margin improvement and sales growth associated with the balance.

David Strauss – UBS

So Jim, just so I’m clear, you’re saying it’s roughly $350 million in charges you took in ships and then you’ve got about $150 million of positive that nets out to the negative $200?

James F. Palmer

Let me go through the exact numbers with you. $326 million in the first quarter offset by $63 million of pick up or reversals in the third and fourth quarter on LHD 8 for a net of $263 on LHD 8 for the year. Then, $59 or $60 million of patent infringement settlements that again, kind of one time impact that net the $200 million.

Operator

Your next question comes from Troy Lahr – Stifel Nicolaus & Company.

Troy Lahr – Stifel Nicolaus & Company

I was just wondering if you guys could talk a little bit about your international sales. Some of the other companies have done a pretty good job of just breaking that out and kind of talking about some of the opportunities in growth there. Could you do the same?

Ronald D. Sugar

Well, as you know we have probably 7% or 8% of our sales in international. This is probably lower than some of the other players, at one time Northrup historically had almost half of its sales internationally, this was quite a number of years before my time. We do have a number of opportunities, a lot of our opportunities are on the electronics area which is our largest international participant.

We do see opportunities for programs such as E2 perhaps in the Middle East. We have some new opportunities there, we have some discussions in India. The F16 SABRE radar which is a new modernization, upgrade to the radars of F16s for the fleet that is deployed around the world, is very significant for us and while there wouldn’t necessarily be sales of new aircraft there would be total replacement of radars and that could be a significant opportunity for our electronic folks as well.

Troy Lahr – Stifel Nicolaus & Company

Do you see that 7% to 8% growing? Is there a certain target that you have out there? Do you think it could get up to 10%?

Ronald D. Sugar

We’ve said for several years that we have not set and I have not set a specific target that says we need to achieve a certain fraction of our portfolio. We’ve got to go where the market is for what we can do well and make money at and my guess is that our proportion will probably remain about there for the next year or two.

What I would like to do now is a couple of closing remarks. Basically I’d like to reiterate that mentioned at the beginning, Paul Gregory will be taking the investor relations role from Gaston. Paul has been the Chief Financial Officer at our space technology sector until this point in time and a long term Northrup executive. I do want to thank Gaston, this completes his 64th quarterly conference call over the last 16 years and I think one or two of you said he has some battle scars and deserves some medals and we would certainly agree with that.

We very much want to thank you Gaston for your service to the company and to the wall street community as well. You’ve been a fixture and you’re probably the longest serving investor relations guy, at least in our industry, maybe in the universe for all we know. Gaston will not be disappearing, we’re going to use Gaston’s perspective and his market focus to help us in the next couple of years as we think through how we can focus on some competitive initiatives across the corporation and Gaston will bring his knowledge and a sharp scalpel with him as we go forward in that effort. We very much appreciate Gaston your help.

That ladies and gentlemen completes our call. Thank you for your interest and we’ll talk to you next quarter.

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Source: Northrup Grumman Corporation Q4 2008 Earnings Call Transcript
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