Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Paul Gregory – VP of IR

Ron Sugar – Chairman and CEO

Wes Bush – President and COO

Jim Palmer – Corporate VP and CFO

Analysts

David Strauss – UBS

Sam Pearlstein – Wells Fargo

Doug Harned – Sanford Bernstein

Joseph Nadol – JPMorgan

Howard Rubel – Jefferies & Company

Brian Ruttenbur – Morgan Keegan

Cai von Rumohr – Cowen & Company

Ron Epstein – Merrill Lynch

Robert Stallard – Macquarie

Northrop Grumman Corporation (NOC) Q2 2009 Earnings Call Transcript July 23, 2009 11:30 AM ET

Operator

Good day ladies and gentlemen, and welcome to the Northrop Grumman second quarter earnings conference call. My name is Glenn and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator instructions).

I would now like to turn the presentation over to your host for today’s call Mr. Paul Gregory, Vice President of Investor Relations at Northrop Grumman. Please proceed.

Paul Gregory

Great, thank you Glenn. Good morning everyone and welcome to Northrop Grumman’s second quarter 2009 conference call. In support of today’s call, we’ve provided supplemental information in the form of a PowerPoint presentation that you can access at www.northropgrumman.com. Before we start, please understand that the matters discussed at today’s call constitute forward-looking statements pursuant to Safe Harbor provisions of Federal Securities Law.

Forward-looking statements involve risks and uncertainties, which are detailed in today’s press release as well as our SEC filings, and may cause actual company results to differ materially. During today’s call, we’ll discuss first quarter 2009 results and guidance for the year. 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 the call today, are our Chairman and CEO, Ron Sugar; our President and COO, Wes Bush; and our Chief Financial Officer, Jim Palmer.

Please proceed to slide three. And at this time, I would like to turn the call over to Ron. Ron?

Ron Sugar

Thank you Paul and good morning everyone. Thanks for joining us. My comments will address our second quarter results, year-to-date cash deployment, guidance for the year, the market environment and our new business pipeline.

Overall, our portfolio performed well in the second quarter. This quarter’s results reflects higher pension costs as well as the aggressive actions we are taking on the Gulf Coast shipbuilding programs to improve performance. Year-to-date, we are on track and we are confirming our 2009 guidance.

On a consolidated basis, second quarter sales grew by approximately 4%. Year-to-date sales have grown by nearly 6%, led by our highest margin business electronic systems with second quarter sales growth of 18% and a year-to-date increase of 17%. At the midyear mark, we are on track to achieve our sales guidance of $34.5 billion for the year.

Operating performance is in line with our expectations for the year. At our May investors conference, we indicated that we might have additional bumps in the road in shipbuilding, which were considered in this year’s EPS guidance. Second quarter results for shipbuilding reflect the cost to drive continuing improvement in our Gulf Coast operations. Wes will provide more insight into our improving actions shortly.

While GAAP EPS shows a year-over-year decline, principally driven by the change in the net FAS/CAS pension expense, our pension adjusted EPS increased 7% to $1.36 versus $1.27 last year. As I said on last quarter’s call, pension adjusted EPS is a better measure of our underlying operating performance. On a year-to-date basis, our pension adjusted EPS of $2.68 is 40% higher than last year. We are confirming our 2009 GAAP EPS guidance of $4.65 to $4.90.

Cash from operations in free cash flow were solid, allowing us to continue executing our balance cash deployment strategy. During the quarter, we increased our dividend by 7.5% and we repurchased nearly 5.8 million shares of common stock. Year-to-date, we repurchased nearly 10 million shares, leaving us with a remaining authorization of slightly over $500 million.

For the year, we continue to expect cash from operations of $2.7 billion to $3.2 billion and free cash flow of $1.9 billion to $2.4 billion, both of which are before $500 million of discretionary pension plan contributions.

New awards for the quarter totaled $7.5 billion and this doesn’t reflect potential backlog and revenue from large ID/IQs such as the A-10 program, the Technical Services won this quarter and the VIS-X program that Electronic Systems won. These billion dollar plus contracts have minimal initial impact to new awards and backlog, but will generate income as we receive task orders.

Year-to-date, we have booked nearly $15 billion in new awards, which is consistent with our expectation for the timing of awards this year. Total backlog at the end of the second year was slightly more than $70 billion after adjustment for the KEI termination.

Looking ahead, Northrop Grumman continues to be strongly positioned for a future national priorities. We have a robust opportunity sets that includes near-term competitive opportunities like the Navy’s CANES acquisition, the Air Force’s GPS OCX contract, the Navy – the Army’s Aerial Common Sensor and of course the Aerial Refueling Tanker.

Looking at the defense and national security spending environment, the administration has made some definitive program decisions in their 2010 budget proposal and now Congress is weighing in. The quadrennial defense review and the FY ’11 budget processes are well underway. The results of these efforts will give us a better understanding of the administration’s longer-term priorities and plans. It will be a balancing act between addressing dangerous national security threats and fiscal spending constraints.

We believe that there will be strong demand for Northrop Grumman’s products and services in this evolving national security environment. These include unmanned aircraft led by Global Hawk, BAMS the Navy UCAS program and Fire Scout. Manned aircraft with continuing production of the F/A-18 and growing production of the F-35 and the E-2D Advanced Hawkeye, there will be electronic sensors, C4ISR, and other intelligence capabilities and finally hybrid security solutions.

In summary, our primary focus continues to be on reducing risk, improving performance and positioning for growth. We believe we continue to have tremendous value creation opportunity for our shareholders.

And now before I turn over the call to Wes for additional discussion on Northrop Grumman’s operations, let me mention that this month marks the anniversary of two very important historical events involving our company. 40 years ago, the Grumman Lunar Module safely transported humans to and from the surface of the moon. And 20 years ago, the Northrop B-2 Stealth Bomber made its first flight, dramatically advancing America’s global strike capability. The 120,000 men and women of Northrop Grumman make enormous pride in the contribution that this company has and continues to make for our nation.

Now, I would like to turn the call over to Wes.

Wes Bush

Thanks Ron. Good morning, everyone. This quarter the company demonstrated solid operating performance in our Aerospace, Electronics, Information Systems and Technical Services sectors. As we described at our investors conference a couple of months ago, we are in the process of making major improvements to our operating approach in our Gulf Coast shipbuilding operations. This quarter, we have reflected cost impacts on the LPD and LHA programs that result from the deliberate actions that we are taking to drive improvements in our Gulf Coast design, engineering, production and quality systems.

The changes we are making began with an absolute commitment to the quality of the ships that we are delivering from our yards. Over the past several years, we have experienced a series of quality related issues with related financial impacts and all of the changes that we are making from design and engineering through production and testing are grounded in a firm commitment to product quality. This means that some processes will cost more than when they were initially estimated. For example, we have instituted a 100% inspection regime on piping and electrical work and we will maintain this degree of quality oversight until we have objective evidence that our manufacturing and production processes warrant a reduced inspection approach.

But the implications of these fundamental commitment to quality go far beyond inspection. We have implemented a shorter cycle build sequence management approach for all of the programs in the Gulf. Every major program phase is subdivided into shorter phases, each with strict entry and exit gate criteria that must be reviewed by management. This approach forces strict management decision making on each sequence of the build cycle and it drives work to be completed within its defined phase of the sequence.

This approach should dramatically reduce the downstream impact of quality issues and the related rework implications, a progressing work that is not ready to move to the next step. The process of changing the program execution plans to this new approach will illuminate actual cost and schedule variances earlier in the program lifecycle than would have been visible in the prior production system.

Incorporation of this management approach has increased the EACs for all of the LPDs that we have under construction. This gated decision making approach also includes assessments of engineering readiness. In fact, our cost growth on the LHA 6 is driven by our assessment that we need to delay the delivery schedule on this ship to enable the engineering work products to reach a higher degree of completeness before moving into substantial production.

In addition to our commitment to quality, we have also transformed our operating approach to build our program execution around class build plans that enables a full benefit of serial production. We have also instituted improved production management tools that provide an increased visibility into the impacts of labor resource sequencing across the entire Gulf Coast operations. These changes taken together have resulted in substantially improved execution plans for the ships under construction in the Gulf. The increased costs of these plants are reflected in the charges taken in both the first and second quarters.

We have now reviewed all of the major Gulf Coast programs. Although, we may still have challenges on these multiyear programs, we have taken a big step forward in managing future program risk and variability. A changed process of this magnitude is a marathon, not a sprint and we expect there may be additional challenges as we are now with this new operating system. But we expect to begin to see reduced variability in our program execution as we proceed into next year.

The bottom line is that we are taking deliberate and proactive steps to improve performance and predictability in the Gulf. Our 2009 guidance contemplated the potential for additional risk on the Gulf Coast and we are on track to achieve this year’s guidance for the company. As a management team, we are committed to proactively managing risk and getting out ahead of issues, both operationally and financially. We are positioning Northrop Grumman to power through program challenges while continuing to deliver solid financial results.

There were several key deliveries and milestones our shipbuilders achieved this quarter. We delivered the George H. W. Bush, the nation's newest and most advanced nuclear powered aircraft carrier. We also delivered the Makin Island under LHD 8, which by all accounts is getting very positive reviews from our service men and women.

The Aegis-guided Missile Destroyer Dewey, the DDG 105, successfully completed her combined super trial on the Gulf of Mexico, paving the way for delivery for the Navy later this summer. And on June 27, the USS New York or LPD 21 built with steel from the World Trade Center was put to see for builder ship trials. We are confident that despite our challenges, we have an incredible amount of opportunity here to improve returns as we turn this business around.

So now let’s talk about the operational performance of our other businesses. Beginning with Aerospace on slide five, we had another strong quarter with solid 8% year-over-year sales growth and a strong margin rate. Growth continues to be driven by our industry-leading position in UAVs, our position on mature manned systems like F/A-18, E-2C, Joint STARS and B2 and the transition to production on programs like the F-35. We also saw solid growth on our restricted programs.

During the quarter, we delivered the final center fuselage for the SDD phase of the F-35 program and we delivered the first center fuselage for the production phase of the program. We also introduced the Black 40 Global Hawk and we delivered the first center an aft/fuselage for the F/A-18F Super Hornet for the Royal Australian Air Force.

Another highlight was the Lunar Crater Observation and Sensing Satellite which was launched by NASA in June and is well on its way to collecting data that will indicate whether there is water on the moon. Looking forward, Aerospace Systems backlog remains robust at nearly $25 billion. New business award highlights included the $432 million award for the E-2D Advanced Hawkeye production as well as the key win of the Navy’s Maritime Laser Demonstration program. This is an important Northrop Grumman technology that we hope to leverage for future growth.

One slide six, Electronic Systems posted another truly outstanding quarter with 18% sales growth and 25% operating margin growth. We continued to see strong demand across the board for our electronics products. New business capture during the quarter included a $400 million follow-on award for Sivers, as well as the competitive $2.4 billion VIS-X ID/IQ win for our joint venture with Cobham. One of the losing VIS-X competitor subsequently filed a GAO protest and the GAO has until October 28th to issue a decision.

Information Systems on slide seven had a solid quarter, particularly in the area of new business and positioning for growth. For the second consecutive quarter, we had terrific revenue growth in our intelligence and defense businesses, 15% and 10% respectively, while maintaining operating margin rates. The growth in these two core businesses reflects our strong position in the ISR and cyber security markets.

Sales for state and local programs declined, which reflects the wind down of programs like New York City Wireless and a more disciplined approach to new business pursuit in this market. The Virginia IT outsourcing program, or VITA, has been in the new quite a bit recently. As we have executed the transformation program, it has become clear that the scope of the effort is substantial greater than initially planned.

We are working closely with the Commonwealth to address growth in contract scope and to improve the working relationships with the many state agencies involved in transformation, some of whom have previously been reluctant to engage in the transformation effort. While transformation is not yet complete, we are making progress and many agencies are already enjoying the benefits of working in this new environment.

The new business outlook in IS remains excellent. In June, the Air Force awarded Northrop Grumman, a $276 million contract for a fielding and operational deployment of the Battlefield Airborne Communications Node, or BACN, an airborne communication system that provides war fighters with critical, real-time battlefield information. The tasking includes installing BACN on two Global Hawk Block 20 unmanned aircraft. There are also several major opportunities that IS is pursuing including GPS OCX, CANES and ACS.

Moving to slide nine, second quarter performance in our Technical Services sector was very strong with double-digit sales growth for the second consecutive quarter. A highlight for the quarter was being one of three contractors selected for the A-10 Thunder Bolt lifecycle support contract. We continue to weigh the Air Force award of the KC-10 contract or logistic support contract which is now expected in the fall.

So in summary, my key operating priority is superior execution across our 20,000 programs and we are taking the deliberate actions that are necessary to improve performance across all of our businesses. And with that, I will turn the call over to Jim.

Jim Palmer

Thanks Wes. Good morning ladies and gentlemen. My comments focused on the second quarter performance and our guidance for 2009. As both Ron and Wes have mentioned, overall, it was a solid quarter. The quarter of our aggregate results somewhat mask by the aggressive actions we are taking in the Gulf.

We had excellent sales and income performance particularly in Aerospace, Electronics and Technical Systems. And what I would characterize is essentially on plan performance in Information Systems. Based on our year-to-date results, we are on track to meet our overall 2009 guidance.

I continue to be pleased with our top line performance. All of the sectors with the exception of shipbuilding had positive sales growth for the quarter. Information Systems grew at 3%, but I want to reiterate what Wes said about the combined growth rate for our intelligence and defense business. These two businesses combined grew in the range of 12%, much higher than the overall growth rate of IS, all while maintaining their margin rate in the combined businesses.

The demand for our core operands in these markets continues to be strong and demonstrates the strength of our defense and intelligence position. The consolidated growth rate does include lower state and local revenue in keeping with our more selective approach to that market.

Second quarter fully diluted GAAP EPS decreased by $0.19 from 2008. However the primary driver of the EPS decline is the year-over-year change in net FAS/CAS pension cost, which totaled $145 million or $0.28 a share. Pension adjusted EPS increased by $0.09 or about 7%. And year-to-date, our pension adjusted EPS is up 40%. The other EPS drivers for this quarter were the $0.21 shipbuilding charge and the $0.13 legal gain.

Second quarter operating income was 8% compared with 9.1% last year. The reduction is primarily due to the shipbuilding charge, so without the shipbuilding charge, segment operating margin rate would have comparable to last year, reflecting the strong performance in the rest of the portfolio.

We did have strong margin performance in Electronic Systems, Aerospace Systems and Technical Services. In Information Systems, margin rate was a bit lower than last year, but that is primarily due to the lower margin rates in the state and local programs that were recognized in the prior year period.

Turning to slide 10, second quarter 2009 cash performance was strong. And we are right about where I expected to be through the first six months. And on the year-to-date basis, both cash provided by operations and free cash flow are comparable to where we stood at the six month mark in 2008, one adjusted for this year’s discretionary pension and pre-funding contributions.

Collections were strong this quarter and we made good progress in improving our working capital from where we stood at the end of the first quarter. And as I said last quarter, I expect that 2009 cash from operations will be once again weighted towards the second half of the year and I again would remind you that our cash flow guidance for 2009 is before the discretionary prefunding of our pension plans.

We continued to execute our cash deployment strategy. Ron mentioned the share repurchases that we made this quarter, 5.8 million shares that have cost of about $273 million. And on a – and we have about $500 million remaining on our current authorization.

We also continued to effectively manage our liabilities. In the first quarter, we made a discretionary pension contribution of $214 million and in July, we contributed an additional $286 million with obviously will be reflected in third quarter results. By making these discretionary contributions, we are reducing future funding demands and building on our industry-leading pension position.

Now let’s move to guidance for the year which remains at $4.65 to $4.90 on a GAAP EPS basis. When we established our 2009 guidance, we clearly communicated that we considered risk and opportunities in establishing that guidance. For example, a potential shipbuilding charge in the magnitude of the second quarter charge was considered in our overall corporate level guidance.

Looking ahead, we still have risk and opportunities. Clearly there are some areas where operational performance can be improved essentially reducing ongoing risk, particularly in the Gulf and on the VITA contract. These are the remaining no one operational risk have been considered in our overall guidance for the year.

The actions and associated charges we took in the Gulf in the second quarter have reduced our sales expectations for shipbuilding to the lower end of our lower guidance range we provided in May and I now expect a margin rate of about 5% for shipbuilding for the year. Until we consistently see the benefits from the operating system we have put in place in the Gulf, some operating risk remains. However, on a longer-term basis, a turnaround of these operations represents our biggest opportunity.

On VITA, Northrop Grumman and the Commonwealth of Virginia are working to resolve contract requirements growth to reduce cost and to complete the transformation across all of the agencies. We anticipate that these effort will succeed, but if we aren’t able to make substantial progress on these fronts, there is some financial risk on the contract.

As the management team, we continue to be keenly focused on aggressively addressing risk and proactively managing it as we go forward rather than taking a wait and see attitude. I should also mention that there are opportunities that we have considered in our guidance including the continued strong operating performance particularly in Aerospace and Electronic Systems as well as the potential for lower tax rate this year.

So in summary, a good quarter, one in which we continue to focus on proactively managing risk and improving performance. Paul, I think with those comments, we are ready to turn it back over for Q&A.

Paul Gregory

Very good. Thank you, Jim. Let’s go ahead and begin. So Glenn, if you could queue up some questions.

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from David Strauss from UBS. Please proceed.

David Strauss – UBS

Good morning.

Ron Sugar

Good morning, David.

Wes Bush

Good morning, David.

David Strauss – UBS

Look, Jim – looking at your sales guidance, it looks like that you are assuming flat to slightly lower sales in the second half. Is that right? And if so, what’s driving that?

Jim Palmer

Good morning, David. Essentially the strong – really strong sales growth that we have seen in electronics for the first half of the year, I don’t know that – I expect to continue at about the same level. If you look at last year, we had very strong sales growth in Electronics in the second half of the year which continued into the first half of this year and then into the second half of next year, so – second half of this year. So essentially, we are catching up with the growth that we have experienced last year and continuing into this year and then continuing for the balance of the year, but the rate of growth will slow.

David Strauss – UBS

Okay. And then on, by segment, I have been hearing updates in terms of your margin guidance and specifically looking at ships I think you had said previously that 7% will be a good performance. Obviously with the charge now, it is going to be tough to get there. What should we kind of look for out of ships on the margin side for the full year now?

Jim Palmer

Yes, David, maybe I have missed it in my comments. But I had about a 5% margin rate for shipbuilding as my thoughts about guidance for them for the balance for the year.

David Strauss – UBS

Okay. I made a mistake. I apologize. And then Jim, just an update on pension, kind of year-to-date performance and maybe if you could some sort of – some sort of help in terms of how we should think about it for 2010.

Jim Palmer

Through June, we are positive to 2%, 2.5% and that kind of range in terms of pension performance as – so that the issue is essentially in thinking of that pension expensive in 2008 go to performance on the plan and about a 100 basis point move in performance versus the 8.5% long-term assumption is about kind of $35 million impact on 2010 expense.

And the other big variable is the discount rate and a 25% -- a 25 basis point rather move in the discount rate generates about a $75 million change in pension expense. So if I would have look at where we were at the end of June, 2.5%, because there is some exposure to expense in 2010 based on the variance between 2.5% and 8.5%.

And likewise the discount rate, if we were setting rates at the end of June, we probably move up 25 to maybe even 50 basis points in terms at a discount rate, so that tends to offset some of that variability. But essentially as you know, all of this is conjecture at this point, we set the number at the end of the year based on actual returns and actual discount rates at the end of the year.

David Strauss – UBS

And then (inaudible) you are just speaking from the FAS side, right?

Jim Palmer

Right.

David Strauss – UBS

All right. Thanks.

Jim Palmer

Yes, all right.

Operator

The next question comes from Sam Pearlstein from Wells Fargo. Please proceed.

Sam Pearlstein – Wells Fargo

Good morning. Wanted to some kind of dig into ships a little bit more, I think Wes at the analyst meeting you talked about that after going through the performance this year you hope to have the business in shape going into 2010 to be stable as you exit the year. I guess, one is, do you still feel that way? And then if I look at just this quarter ex the charge, you are doing margins on the order of 7.8%. So trying to figure out why we are not going to see that kind of performance even in the second half of this year.

Wes Bush

All right, Sam. Let me talk a little bit about first your question on the timing the stability. And – as we said at the investors conference and the story is still the same that we are working hard to drive these improvements in our Gulf Coast operation. It really does take a little bit of time to change the processes that we are utilizing that really mirror a lot of the very successful processes that we have instituted in programs where we have real class build activities underway like Virginia class.

And I do continue to expect that it will take us through the reminder of this year to really get these new operating systems ironed out and up and running and I think it will be into the beginning of next year before we can really make that solid assessment on stability. But as I said in my remarks, we do see the actions that we have taken here in the first two quarters is a big step forward in driving that stability, ironing out the variability and really getting our arms around the risk profile. But I am still in the same place I was at the investors conference.

And then with respect to the margin rate, I think Jim addressed that very directly with respect to what our expectations would be for this year. Overall, our booking approach in ships, I would characterize as a more conservative booking approach and we are not at a point of giving an outlook on that for next year quite yet. But I think you will continue to see us reflect that more conservative style and the way that we are thinking about our programs in the Gulf.

Sam Pearlstein – Wells Fargo

Okay. Thank you. And then just a follow up with Jim, if sales for ships are going to be towards the lower end of the range and the margin is going to be about 5% I guess. Can you talk about the other segments in terms of what’s going to be the offset to that in order to continue to hit the overall sales and the earnings guidance?

Jim Palmer

Sam, as I said in my closing comments, I expect continued strong performance out of both Electronics and Aerospace in particular. In terms of margin rate and I think our range had been – guidance range had been mid-to-high 12%. I feel good about where they are in terms of ability to meet that guidance range. In Aerospace, about 10% has been our guidance and again I feel good about that. There maybe a little bit of upside to that depending about the various programs for the balance of the year. But essentially that’s the swingers as I look at the balance of the year.

Sam Pearlstein – Wells Fargo

Okay, thank you.

Operator

The next question comes from Doug Harned from Sanford Bernstein. Please proceed.

Doug Harned – Sanford Bernstein

Good morning.

Wes Bush

Good morning, Doug.

Jim Palmer

Good morning, Doug.

Doug Harned – Sanford Bernstein

On ships, Wes, when you walked through some of the things that you intend to do, the improvement in processes and taking some of the lessons learned from Newport News to the Gulf. I am trying to understand how they get confidence in there. And Mike Petters has been leading this organization for about a year-and-a-half now and you’ve brought in Irwin Edenzon, have you brought in other people from Newport News. In other words, how are you getting the talent leadership in there to make sure that these kinds of changes and really take hold?

Wes Bush

Doug, it’s – we talked a little bit about this in the investors conference, but I think it’s probably an appropriate time to give a little bit of a broader perspective. We have been making changes across the board in the Gulf Coast operations and it’s of course much more than Mike and Irwin Edenzon, although it’s critical of course to have the right leadership at the top to really drive the improvement programs and I am very pleased with the work that both Mike and Irwin doing in driving. But beyond that, we have restructured the overall leadership approach, both organizational structure in terms of how we are driving the programs as well as the functional organization and the people. And if you look at the top player management, these changes have impacted about 75% of the senior management positions in the Gulf Coast and that means both the arrival of talent from outside of the Gulf Coast as well as the redeployment of some really good leadership talent that we have in the Gulf Coast. So it’s been a restructuring of the approach that that we are taking.

Those – that set of change has really occurred over the course of last year as we were getting our arms around how we wanted to execute the business and restructure the operating approach and getting those people in place, getting the organizational approach in place last year. They have enabled us to use that team to define this operating system that I was just describing earlier to really move out and implement this little bit different way of doing business. And so we not only have a team in place, we have ownership of what we are doing that I think is just going to be absolutely critical to the success for making progress.

You asked about how can we tell if we are making progress, we are going to be talking to you about this every single quarter, you can bet on that as we go forward. But beyond, obviously our communications with all of you, I am spending a lot of time on this, Jim is spending a lot of time on this in detailed reviews both at the program level as well as I would say some other leading indicators that we look at in terms of the front-end work and the quality indicators.

One of the things I talked about at the investors conference was the time it takes to really turn things around in a broader quality perspective. And it’s reflected a lot in the changes that we are making on this, driving the rigid adherence to sequence controlling the programs.

When you think about where we are on many of the programs that are reflected in the charts that we took in the quarter, many of those activities have a status of production that’s well downstream. And so issues that may have been manifested by virtue of earlier decisions on sequence control, we are having to work our way through those today with the team is in place.

And so we have got a little bit of work still in front of us to really get our arms around all of those activities and get them operating the way we really wanted to operate. So it’s a – it is a tops to bottom set of changes that we are making and I feel very good about the progress, but again, Doug, we are going to be talking about this every quarter, because we understand that it’s an area of intense interest to many of you and you need to see the progress as well.

Doug Harned – Sanford Bernstein

And I want to ask a follow-on on IT, I just can’t, I mean the LHA 6 is, I mean this – this – you were cutting metal of the beginning of ’08 when you made the management team, so this one doesn’t have to seem as much legacy issue in it.

Wes Bush

Yes, Doug, the focus on LHA 6 has really taken a lot of the lessons learned from a number of programs including LHD 8, where it’s very clear that we need to make sure that the engineering products are at the level of completion that enable us to move in to substantial production with confidence that we are not going to be having to rework as we finish up some of the other engineering activities. Earlier this year, when you said cutting metal, we were at a very, very low level of early production. So this is the right time to really drive home the engineering completeness before we move out.

Doug Harned – Sanford Bernstein

And then on – on VITA, you talk about – you talked about two issues, one, contract requirements growth and then, getting a better relationship with the agency in the state. But if you look at the issues that have come up earlier in the audit and a lot of the things that have been politically charged I would say within the State of Virginia, those don’t appear in the service of me at least to be contract requirements growth, a lot of them are back to this building the relationship with these agencies and the difficulty it appears that you have had in getting traction with those agencies and that may not be at all your fault. But you have had a fair amount of time to be down there. I mean how do you see this unfolding? What can you actually do to get the agencies on board, make sure you are going to be paid and then how much risk is associated with this if that doesn’t work out until right at the transition?

Wes Bush

So, Doug, let me give you a perspective on VITA that I think is difficult to get from media reports. Media reports give you a very narrow window into a view of a program of dis-complexity. They’re really usually focused on quotes from individuals that are looking at the program in a certain way.

Doug Harned – Sanford Bernstein

Well, I am talking about – also the transcripts of hearings audit documents.

Wes Bush

All right. So let me give you a broader view. We’re undertaking in Virginia a major IT transformation activity that spans across many, many different agencies, each with their own operating culture, each with their own history of how they have used IT systems. And as you think about the cultural complexity of going through that amount of transformation, there are a lot of human dynamics involved in it. And so separating the issues out into narrow buckets of, well, this was a building issue or this was a issue around inventory, they turn out to be highly interrelated. Where we see the status on the program and the issues on the program, be very direct about it, there is a lot of issues to go around.

We’ve not been perfect in our execution and we’ve had a number of issues and working this with the state and the variety of different agency involved. And we are having to work the resolution of all of these things very closely with the Commonwealth, despite perhaps the negative tone that shows up in many of flash to your media reports. And we see this on a path of constructive resolution. But it’s going to take more than just Northrop Grumman doing all the things that we can do to make this work right.

As you know, there has been a fair amount of recent attention by the General Assembly, I guess that is called and the Governor’s office highlighting the fundamental governance challenge, given that VITA reports to an Independent Board and various agencies that are undergoing transformation, all have very different reporting structures. We are glad to see that getting highlighted. We think it’s important that that issue get out on the table and it gives us some confidence that the governance will get addressed as a part of the overall resolution in getting to closure here.

So there are contractual changes that need to occur, there are governance changes that need to occur and there is programmatic changes that need to occur. And we are working all of those fronts to make sure that we get there. The issue obviously is getting through the transformation phase and migrating into the ongoing managed services phase. That’s going to take a little bit longer to get through the transformation phase.

We are working with the state to define that timeline. But from what we can see so far at the working level of all the folks that we interfaced with, there is a recognition that we got to work this together to get it done. It’s the best interest of the state; it’s the best interest of the company.

Doug Harned – Sanford Bernstein

And can you dimension the risk on this as you see it going forward?

Wes Bush

It’s a contract like any other contract, we – if you’ll think about it broadly, we have gone through our thought process on the range of risk we have contemplated that in our guidance approach. So I wouldn’t try and quantify any particular contract risk as we typically don’t do that with others.

Doug Harned – Sanford Bernstein

Okay, well, thank you.

Wes Bush

Thanks Doug.

Operator

The next question comes from Joseph Nadol from JPMorgan. Please proceed.

Joseph Nadol – JPMorgan

Thanks, good morning.

Wes Bush

Hi Joe.

Joseph Nadol – JPMorgan

Wes or Jim, could we walk through four different programs, I am sure you know which ones they are already. And just go through the contract types and where we are if they’re fixed price, are we in a loss position, just to help us gauge maybe a little bit more carefully what the incremental risk might be. DDG 51 which you were clean on this quarter, but you had charges last quarter, obviously the LHA 6, LPD 17 and then VITA?

Wes Bush

VITA is essentially, we characterize it as a fixed price contract. The fee for service rates are determined, then so the key will be future revenue streams resulting from volume compared to actual cost of providing that – DDG 51s are fixed price incentive, LHA 6 is a fixed price incentive, and I forgot the fourth one Joe.

Jim Palmer

LPD.

Wes Bush

LPDs.

Jim Palmer

Fixed price incentives.

Wes Bush

Fixed price incentives.

Joseph Nadol – JPMorgan

So all three of the ships are fixed price incentives. Are there any kind of cost shares in any of those are they simply just –

Wes Bush

No, they’re a – fixed price incentive means that there is a incentive sharing of cost above or below a target cost to a point of ceiling or total assumption.

Joseph Nadol – JPMorgan

Right. So is there any share left on any of those three, are we in the 100% fixed price mode at this point?

Wes Bush

On depending upon which ship, so each of these are essentially different contracts. There is not one contract, for example, for LPDs. There are a series of contracts for LPDs. So depending upon which ships there are – some cases, essentially fixed price. In other case, they are fixed price incentive with ceiling production still remaining.

Joseph Nadol – JPMorgan

Okay. So there is no way to characterize which we have more room to go on – on generally speaking – and do you have a multiyear on DDG 51 anyway? Is that really more than on contract?

Wes Bush

No, we are under contract for the two remaining ships, DDG 51s to be delivered. One off – I guess it’s three. 105 is being complete, it’s on its sea trials, 107 and 110.

Joseph Nadol – JPMorgan

Okay. And then – just in that, you mentioned tax rate Jim, you may have opportunity there. What’s embedded in your guidance right now and has that changed and how much opportunity in there?

Jim Palmer

Actually Joe, in the Q, we disclose that there is the potential for about $50 million reduction in taxes this year as a result of – if we are able to bring the closure, the resolution on an IRS dam. That equates to about $0.15. And I thought about my risk and opportunities, I weigh both the risk and opportunities and come up with that overall range.

Joseph Nadol – JPMorgan

Okay. So it’s factored and maybe partially is the way to think about it.

Jim Palmer

Yes.

Joseph Nadol – JPMorgan

Okay. All right, thank you.

Jim Palmer

Thanks.

Wes Bush

All right.

Operator

(Operator instructions). Your next question comes from Howard Rubel from Jefferies & Company. Please proceed.

Howard Rubel – Jefferies & Company

Thank you very much.

Ron Sugar

Good morning, Howard.

Howard Rubel – Jefferies & Company

Gentlemen. Thinking about the cash deployment and what you’re going to do all the opportunities. Do you – as you look out, do you just continue to see the best opportunity as share or continue to do balance of share repurchase and dividend increase. And where do you think you would look for an optimal capital structure, because clearly, you are in a great position today relative to where you have been?

Ron Sugar

Howard, let me kick that off. This is Ron. And first of all, we are interested in building this company and building the shareholder value with it. We do have the balance cash deployment strategy we have been very faithfully executing probably for the last five years or more. And we have, you are correct, put ourselves in a very strong balance sheet position, strongest in our company’s history actually.

We see balance to deployment with share repurchase dividend increase, capital investment. As we have also stated at the investor conference, we are on a look out for opportunities to improve our portfolio where we see opportunities, particularly in areas that we have discussed such as C4 ISR, cyber, unmanned, and things that we think we are going to be faster moving currents in the future defense environment.

We have been pretty disciplined to this point in time. As you know, we are going down a few of these things a year, they have been fairly small. But the ones we have done we think have had significant impact, for example, the scale composites and the SX. So looking forward, I would expect, Howard, not see a whole different strategy, I think more of the same to some extent opportunity driven with discipline. But we like where we are sitting and we like the options we have. Jim, do you want to add anything on –

Jim Palmer

Ron, I just confirm your comments and confirm that we are happy with our balance sheet structure, capital structure today. We think it’s really important in today’s economic environment that we have the capital structure that we do have. We expect to continue with the rather conservative capital structure in today’s economic environment. I really don’t see a change in our balance cash deployment strategy on a go-forward basis, so continued investment in the business, whether through acquisitions or CapEx, balancing or managing the liabilities, funding the pension plan and returns to the shareholders will be primary emphasis as we go forward.

Howard Rubel – Jefferies & Company

And then just one follow-up. Ron, I am sure you really enjoy getting deep inside the head all the time by all these great shipyard questions. Is there a real consideration at some point, because you do characterize the rest of the portfolio is really being very good and results really standout. I mean, like we are in a business sometimes for managing portfolios to of – you know where this is going. Have you – have you – the thought about saying, you know guys, if you don’t ship up; we are going to ship you out. And put something there that’s a real metric and I mean, I know this is a quarterly call as opposed to a strategic discussion, but there sort of comes a point where you got to realize that how many times do you want to get surprised.

Ron Sugar

No. Well, Howard, obviously this is a portfolio and we are where we are at this point in time. Our focus is pretty much on fixing the business we have. We see this as the most significant improvement opportunity for shareholder value. That’s what we are focused. Obviously from time-to-time, we always consider future options to the company. We don’t comment on those publicly. But our focus is on improving shipbuilding.

And I would point out that the surprise question, we did contemplate this in the guidance at the beginning of year. Jim Palmer and Wes and our team took a careful look of where we thought we would be. We wanted to make sure that we provided you an overall assessment of what your investment we will be able to do this year. We put the guidance forth on that and that’s where we are today. And as you pointed out, every business has portfolio issues from time to time. We were pleased with the over performance we are seeing in several of businesses and we are going to work as hard as we can to make sure they are all extended over time.

Howard Rubel – Jefferies & Company

All right. I can see, I am not going to get a complete answer on it, but I understand it.

Ron Sugar

Thanks Howard.

Operator

The next question comes from Brian Ruttenbur from Morgan Keegan. Please proceed.

Brian Ruttenbur – Morgan Keegan

Great. Thank you very much for taking my question. I was wondering if you can talk a little bit about revenues and margins broken out between the next two quarters, for third quarter and fourth quarter, if you can talk a little bit about revenues and margins and walk us through how you get down to earnings for the next two quarters?

Jim Palmer

Brian, we really don’t go through quarterly forecast. We’ve never have given guidance on a quarterly basis in the past and I don’t think it’s a good practice to start that at this point.

Brian Ruttenbur – Morgan Keegan

Okay. Is the third – the fourth quarter is going to be weighted heavier than the third quarter like we have prudentially seen?

Jim Palmer

What am I going to say? I just said, I am not going to give quarterly guidance.

Brian Ruttenbur – Morgan Keegan

I was just digging trying it from a different angle and okay. Any expected charges in your guidance that you have for the next two quarters?

Jim Palmer

Brian, as I said, I look at the risk and opportunities, I weigh them and come up with the overall guidance and I am comfortable with that $4.65 to $4.90 GAAP earnings per share guidance.

Brian Ruttenbur – Morgan Keegan

Okay. Thank you very much.

Operator

The next question comes from Cai von Rumohr from Cowen & Company. Please proceed.

Cai von Rumohr – Cowen & Company

Yes, excuse me, if this has been asked. I was on another call. But have you talked about pension, your pension performance year-to-date and any kind of color on how we should think about pension next year?

Jim Palmer

Yes, I did have a few comments. But I know it’s an important topic that all of you are interested in, so let me just repeat. Through the – through June, we have pension returns in the – about 2.5% range for the six months. As you know, our long-term earnings assumption is 8.5% and every 100 basis point move or difference between our actual and that long-term rate of return assumption is about a $35 million impact on 2010 FAS expense.

Likewise, discount rate has an impact. The two biggest impacts on going forward, pension cost or the discount rate, and the actual versus the long-term rate of return assumption. If we were looking at discount rates at the end of June and setting discount rates then, we would probably have an increase in the discount rate by 25 to maybe even 50 basis points. A 25 basis point move in the discount rate is about a $75 million change in the 2010 FAS expense.

So those are kind of the broad parameters at this point in time. And again, we got six months to go, none of these rates are established until the end of the year, it’s actual 2010 investment performance and actual discount rate at the end of the year that establishes what the FAS expense will be in 2010.

Cai von Rumohr – Cowen & Company

And what’s your strategy in terms of pension contribution?

Jim Palmer

We, as you know, I think and we have disclosed a – obviously, we fund the required amount of pension plans and we had planned for another $500 million of discretionary contributions, all of which have now been made, we made $214 million in the first quarter and then in my comments, I mentioned that we made the balance, the $286 million shortly after the beginning of the third quarter here, so that will be reflected in the third quarter results.

Cai von Rumohr – Cowen & Company

Okay. Terrific. Thank you.

Jim Palmer

Thanks Cai.

Ron Sugar

Thank you, Cai.

Operator

Your next question comes from Ron Epstein from Merrill Lynch. Please proceed.

Ron Sugar

Hello Ron.

Ron Epstein – Merrill Lynch

Hi, good afternoon. Just to kind of beat the same dead horse here on shipbuilding. Ron, when you look back at that business, and really what’s been the biggest challenge in terms of getting it right, right? I mean it seems like it’s been a bit of bugaboo to get it to where you wanted to be and what’s been the biggest challenge?

Ron Sugar

Well, Ron, first of all, let’s partition the business. This business comes in two pieces, one is the Newport News piece, which is focused on nuclear shipbuilding carriers and submarines and the other piece and roughly divided in half is in the Gulf Coast building surface combatants and amphibs.

I would say that the experience at Newport News since the acquisition of that piece of the business has been very solid. We have seen good performance there. It has in all businesses there are some cycles, but in general, there has been a higher level of predictability there both in terms of the products of the demand curves that’s come from the customer and our ability to put in place the kind of processes and quality methods that are needed for those kind of ships.

In the Gulf Coast, we have seen a much different situation. We have seen a number of very extreme exogenous issues coupled with some internal issues. Exogenous issues have been a very dramatic variability in the predictability of the actual demand of ships down there both in terms of numbers, the different kinds of ships, the number of first-of-class ships that have been required, the number of the schedule those ships in the funding. Of course, the hurricanes have been just significantly disruptive and much more so than I would say than any of us including I really ever realize. And then I would finally say that, our experience has been to a maturity level of some of the processes and systems at the Gulf, even prior to the hurricanes and prior to the volatility in the demand, market demand have not been in the same level as we have seen in Newport News.

So we made the decision, as you know, a year-and-a-half or two years ago, to put the businesses together, a combined management. We have a superior shipbuilding management team running this business. We are putting the right talent where we needed. As Wes indicated, we have made significant changes and structure process and people.

This is long-cycle business. It’s going to take a while to work our way through this. But we do believe that with some stability in the shipbuilding plan and we have some reason to believe there could be some of those coming forward and the ability to get some traction as we are going, we should see a tremendous shareholder value improving opportunity over the next couple of years.

Ron Epstein – Merrill Lynch

Okay. And then maybe more specifically on the Kinetic Energy Interceptor, with that program effectively going away, does that open up other opportunities for Northrop in terms of what’s going to replace it?

Wes Bush

Yes, Ron. There is a very, very serious mission requirement in missile defense to hit enemy missiles early after launch before they are able to get too far down range and deploy potentially multiple warheads or do maneuvering. So if you don’t want to hit in the boost phase, that is when it’s powered, you do want to hit in the ascent phase shortly after the engine cuts off. And we believe that Northrop has a very significant set of expertise in terms of the command and control of a system that would do that.

I think Missile Defense Agency is now contemplating perhaps a different interceptor vehicle, but that is only one piece of the overall system. The challenge is as much related to the sensing and the command and control and directing of the interceptor as it is in building the interceptor. So as the Missile Defense Agency develops its next steps here, we will be working with them very closely.

Ron Epstein – Merrill Lynch

And when would you expect us to get clarity on that?

Wes Bush

We are kind of watching the system develop. I am sure sometime in the next year that’s going to start sorting itself out.

Ron Epstein – Merrill Lynch

Okay, great. Thank you.

Paul Gregory

Thank you. I think we are ready for one more question and then we will be out of time. So last question, please.

Operator

The last question comes from Robert Stallard from Macquarie. Please proceed.

Robert Stallard – Macquarie

Good afternoon.

Wes Bush

Hi, Rob.

Robert Stallard – Macquarie

Hi, just a quickie, on your service side, haven’t you seen any delays in funding for any of your programs due to the change in administration?

Ron Sugar

Not due to the change at administration, Rob. But we have seen a long protraction in the award of a number of very large competitive logistics and support contracts. For example, the C-20 program which we had won and went into protest and the KC-10 program which is very large.

KC-10, as you know, is one of the two tanker types which is currently being flown by the fleet and we are in a competition for that one and the competition down select date continues to ship to the right and does have some impact in terms of our ability to forecast, hopefully improved revenues and margins there. And we are a pretty much at the mercy of the procurement process for that.

Robert Stallard – Macquarie

Okay. And just quickly on the UAVs, Ron, you mentioned this is an area of potential growth going forward. How has your performance been versus cost and execution and timing on Global Hawk and BAM so far?

Ron Sugar

I think they’ve been very good. There was a little bit of buzz in the process probably about six months ago about, some concerns about Global Hawk and it was unfortunate that it was a letter that related to issues that were at probably about a year-and-a-half or two years old. The fact is that the – the operational performance of Global Hawk in combat has been outstanding. The demand for the system with additional sensors on the airplanes has been very, very strong from the operational commanders.

We have a very, very good production line going now. We are off to a very good start on BAMs, so I think this is a very good program. One of the challenges we’ve run into with our partners the Air Force has been their ability to schedule adequate test time for the machines as we take them off the assembly line, but we are working with them to accelerate that process. But overall, this is a program, which has enormous impact for the future and one I think we are making very progress on.

Robert Stallard – Macquarie

That’s great. Thanks very much.

Ron Sugar

Okay. Well, very well, let me just wrap up the call then by just reiterating, it was a solid quarter overall. We had very strong performance in four of our five businesses.

We are taking aggressive actions in the Gulf Coast and we appreciate your interest and concern there and we will keep you posted every quarter after this on how that’s progressing. We do see this as our most significant opportunity to improve shareholder value.

But if I step back from that, our overall strategic position as we see the emerging defense budgets, we believe is strong and we think that we are going to be well set in the future environment. So I would like to thank all of you for joining us. And we will talk to you next quarter.

Operator

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

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Northrop Grumman Corporation Q2 2009 Earnings Call Transcript
This Transcript
All Transcripts