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Executives

James F. Palmer - Chief Financial Officer, Corporate Vice President and Member of Corporate Policy Council

Stephen C. Movius - Chief Financial Officer and Sector Vice President of Finance and Business Operations

Wesley G. Bush - Chairman, Chief Executive Officer, President and Member of Corporate Policy Council

Analysts

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Robert Spingarn - Crédit Suisse AG, Research Division

Joseph Nadol - JP Morgan Chase & Co, Research Division

Douglas S. Harned - Sanford C. Bernstein & Co., LLC., Research Division

George Shapiro - Citi

Heidi R. Wood - Morgan Stanley, Research Division

Carter Copeland - Barclays Capital, Research Division

Myles A. Walton - Deutsche Bank AG, Research Division

David E. Strauss - UBS Investment Bank, Research Division

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Northrop Grumman (NOC) Q3 2011 Earnings Call October 26, 2011 11:30 AM ET

Operator

Good day, ladies and gentlemen and welcome to the Third Quarter Earnings Conference Call. My name is Anne, and I will be your coordinator for today's call. As a reminder, this conference is being recorded for replay purposes. [Operator Instructions] I would now like to turn the presentation over to Mr. Steve Movius, Vice President of Investor Relations. Please proceed, sir.

Stephen C. Movius

Thank you, Anne and welcome to Northrop Grumman's Third Quarter 2011 Conference Call. We provide a supplemental information in the form of a PowerPoint presentation that you can access at www.northropgrumman.com.

Before we start, please understand that matters discussed on today's call constitute forward-looking statements pursuant to safe harbor provision of federal securities laws. Forward-looking statements involve risks and uncertainties which are detailed in today's press release and our SEC filings. These risk factors may cause actual company results to differ materially. During today's call, we'll discuss third quarter 2011 results, our 2011 guidance for continuing operations and 2012 pension trends. On the call today are our CEO, Wes Bush; and our CFO, Jim Palmer. Please go to Slide 3.

At this time, I'd like to turn the call over to Wes.

Wesley G. Bush

Thank you, Steve. Good morning, everyone and thanks for joining us. Overall, we're very pleased with our third quarter results. We continue to demonstrate that we can generate shareholder value and EPS growth in a challenging environment, by focusing on portfolio alignment, performance and effective cash deployment.

Our strong operational performance, combined with our ongoing share repurchases, generated a 23% increase in EPS from continuing operations. We're particularly pleased with results from the sectors. All 4 businesses generated strong operating income, higher margin rates and healthy-book-to-bill ratios. During the quarter, we repurchased 12.7 million shares, bringing total year-to-date repurchases to 28.4 million shares. At the end of the third quarter, $2.4 billion remained on our share repurchase authorization.

Third quarter free cash flow from continuing operations totaled $839 million. This year, through the end of the third quarter, we've returned approximately $2 billion to shareholders through share repurchases and dividends. New awards were also strong this quarter, totaling $7.8 billion, for a book-to-bill ratio of nearly 120%. As of September 30, total backlog was approximately $42 billion.

Based on the strength of this quarter's results, we are raising our guidance for EPS from continuing operations. We now expect 2011 EPS from continuing operations of $6.95 to $7.05, which at the midpoint of the range, represents year-over-year EPS growth of 20% before onetime items, such as last year's tax benefit and the impact of our 2010 debt tender.

As we've discussed before, we continue to make portfolio-shaping decisions and de-emphasize certain business lines. This includes decisions to exit non-core and underperforming businesses that don't provide attractive financial returns. Recent examples are the sale of the County of San Diego outsourcing contract and our decision to exit the domestic postal automation business. These portfolio-shaping actions have contributed to a year-over-year sales decline but have had a very positive impact on our company's performance.

Excluding portfolio-shaping actions, full 2011 sales would be 2% to 3% lower than last year due to the market environment. Our business continues to be impacted by budget uncertainty. Due to the 6-month continuing resolution process in fiscal year 2011, the potential for an extended continuing resolution, fiscal year 2012, and the possibility of further budget reductions, our customers continue to be cautious in releasing funds for their activities. While there is uncertainty regarding future budget levels, we believe there is clarity regarding the threat environment and our customers' need for affordability.

With the drawdown of In Theater operations over the next few years, we believe the nation will focus on developing affordable solutions to address broader, emerging and more capable threats. In that environment, we expect our relatively low exposure to the OCO budget, which is about 3% of our sales, will benefit us, as will our ongoing effort to cost competitively position our company. We continue to focus on positioning the company to perform in a more constrained environment. It's more important than ever that we continue to aggressively address our cost structure, our operational execution and, of course, our productivity. Over the long term, we believe C4ISR, unmanned, cyber and logistics will continue to be priority investment areas for our customers. This is where a substantial amount of our portfolio is focused and I thought it would be helpful to touch on each area before discussing the sector highlights.

So let me begin with our broad unmanned capability, which in addition to fixed wing and rotary vehicles, also spans sensors and processing. In total, unmanned currently represents about 10% of total sales and it is growing. Global Hawk continues to achieve important milestones and improved affordability. International interest in Global Hawk from our allies continues to grow, and we see this capability as an important part of future commerce with our allies. Our BAMS derivative of Global Hawk is also progressing well. And the X-47B, our unmanned demonstrator for the Navy, recently completed a successful demonstration of ship-based software and systems, that will play a key role in its ultimate operation from the deck of an aircraft carrier. We expect continued strong demand for C4ISR capabilities as the global threat profile continues to expand. Our nation and our allies are increasingly dependent on C4ISR to understand and address these threats, and our extensive sensor technology and our processing capabilities are well positioned to support information-gathering efforts.

In Cybersecurity, we're working with the defense and intelligence communities to address the rapid proliferation of threats. We're also successfully migrating tools and solutions developed for the .mil domain into the .gov domain and this represents a significant growth area for our Cyber work. And in logistics, we continue to address the need to maintain and modernize aging equipment, upon which our customers will depend as the number of new start programs diminishes.

So now, turning to the sectors. In addition to progress on unmanned programs, during the quarter, aerospace was awarded a $795 million contract to continue production of E-2D Advanced Hawkeyes, under LRIP Lot 3 and to procure long lead materials for Lot 4 aircraft. We were also awarded a contract modification for an additional Lot 2 aircraft.

In Electronic Systems, our data program has made tremendous progress in terms of the system design and development. G/ATOR is the first AESA-based multi-mission radar for the Marine Corp. It replaces 5 different legacy radar systems and it's a model for affordability, not only in acquisition cost, but in savings realized in training and sustainability of a single system. With several requirements for other new development ground-based radars being considered by the DoD, the rapidly maturing G/ATOR system provides a highly capable and affordable alternative. And in the third quarter, ES was awarded a contract to deliver advanced threat warning sensors as the latest upgrade to our Department of Navy, Large Aircraft Infrared Countermeasure System, also known as LAIRCM.

In Information Systems, we recently won two key healthcare IT awards. IS received a centers for Medicare and Medicaid past quarter, to develop a system to identify high-risk claims in order to detect and prevent fraud waste and abuse. And we won the Department of Health and Human Services Encounter Data Processing Systems award. EDPS will track and aggregate Medicare data to support risk and pricing models. Both of these awards are aligned with our focus on the higher end, high engineering content part of the healthcare IT market. And our BACN system continues its mission-critical and theater performance. We've received follow-on awards to extend service, continue operations and maintenance and provide essential payload elements for interoperability testing. And the number of go-forward alternatives for additional variants are also being considered.

Technical Services received an award to modernize the unmanned hunter MQ-5B system to a digital configuration, and provide interoperability engineering services for our Army customer.

So in conclusion, it was a very strong quarter. Superior operating execution and effective cash deployment more than offset top line pressure. We continue to demonstrate that we can create value in an environment of constrained top line growth by focusing on our key priorities: Performance and execution that supports our customers' need for affordability, aligning our portfolio with priority areas of customer investment that provide attractive rates of return and effectively deploying our cash.

So now, I'll turn the call over to Jim for a more detailed discussion of results and our guidance. Jim?

James F. Palmer

Thanks, Wes and good morning, ladies and gentlemen. Let me start by offering my perspective on our quarterly results, which I would characterize as a good, strong operating and cash flow result in a challenging environment that continues to put pressure on the top line.

The strong operating performance that I just referred to, together with improved net FAS/CAS pension adjustment, a lower effective tax rate and ongoing share repurchases, combine to generate a 23% increase in earnings per share from continuing operations. On a pension-adjusted basis, earnings per share from continuing operations increased 8%. Once again, operational improvements have offset lower sales, with segment operating margin increasing for both the quarter and year-to-date.

All of our businesses executed well. Operating margin rates expanded in all four sectors and all four sectors generated book-to-bill ratios greater than 1. Quarterly segment operating margin rate expanded 110 basis points to 11.8% and total operating margin rate expanded 230 basis points to 12.5%. I would also note that on a pension-adjusted basis, our operating margin rate expanded 80 basis points for both the quarter and on a year-to-date basis. As a result, pension-adjusted operating margin rate was 11% for the quarter and 10.9% year-to-date.

Given the focus most of you have had on the top line, I thought it was appropriate to spend a few minutes on some of the drivers of our year-over-year sales decline. There are three principal drivers causing the lower year-over-year sales. First, are the strategic decisions to de-emphasize non-core underperforming businesses that Wes referred to. Second is the transition to a units of delivery method on the F-35. And third are the external budget pressures. Much of the decline in the expected full year, year-over-year revenues is driven by our actions to de-emphasize or sell non-core and underperforming businesses. This includes the reduced participation in the Nevada National Security Site joint venture, which accounts for $580 million of reduced revenues on a year-over-year basis, as well as about $250 million that results from de-emphasizing several other businesses and contracts. These include the base operations, some base operation support and Technical Services, the sale of San Diego outsourcing contract and information services and our decision to exit the domestic postal automation business and electronic systems.

I want to reiterate what Wes said. It is important to recognize that these portfolio-shaping actions have contributed to the performance improvement we generated both in the third quarter and on a year-to-date basis. Secondly, with the anticipated move away from the cost-type contracting environment for the F-35 program, we are transitioning to a units of delivery revenue recognition model with LRIP 5, which will reduce 2011 revenues by about $225 million.

The third factor reducing sales is attributed to the customer spending challenges and budget pressures, as well as in theater drawdowns. The current CR and the impact on the current budget reduction discussions continue to constrain customer spending. Our prior guidance contemplated some improvement in the funding environment in the second half of year, which would have offset some of the portfolio shaping and F-35 impacts that I just discussed. But with the impact of the on-going deficit discussions and the current continuing resolution for fiscal 2012, I would now expect our fourth quarter revenues to be roughly comparable to this quarter.

So now, let me spend a few minutes and walk through the third quarter results for each of the sectors. In Aerospace Systems, third quarter sales declined 5% due to reduced funding for the weather satellite programs and the James Webb Space Telescope program, as well as lower volume on several other space programs. Lower revenue on the F-35 program reflects the revenue recognition transitioning to a units of delivery revenue method from a cost incurred method, beginning with LRIP 5. Rather than recognizing sales as costs are incurred, sales will now be recognized as units are delivered. This is essentially a timing difference, which reduced AS sales by about $50 million in the third quarter. The impact of this timing difference will increase over the next few quarters before it begins to reverse in the second half of 2012. Despite lower sales, AS third quarter operating income was comparable to last year. Operating margin rate expanded 60 basis points to 11.8%, due to improved program performance and somewhat lower amortization of purchase intangibles, which were partially offset by a negative performance adjustment on a space program. Based on year-to-date results, we now expect AS sales of $10.6 billion, with an operating margin rate in the mid-to-high 11% range. AS ended the quarter with a total backlog of $18.1 billion, which reflects new awards of $27.0 billion, the largest being the E-2D award that Wes mentioned. Book-to-bill for the quarter was about 105% in Aerospace.

Turning to Electronic Systems, where sales increased 2% due to higher volume for ISR targeting systems and naval marine systems. Operating income at ES increased more than 12% and operating margin rate expanded to 15.4%. Higher operating income and margin rate for the quarter resulted from performance improvements across various programs, including the achievement of a cost incentive for a space program and improved performance on an international radar program. These program performance improvements were partially offset by a $25 million loss provision for a dispute on the Flat Sequencing System Domestic Postal Automation Program, which as Wes mentioned, we are exiting. Based on year-to-date results, we expect ES sales of approximately $7.4 billion, with an operating margin rate in the low 14% range. ES total backlog at the end of the third quarter was $9.9 billion and reflects new awards at $2.3 billion during the quarter with a book-to-bill ratio of about 120%.

Information Systems had sales decline of about 8% for the quarter, primarily due to lower volume for defense and civil systems. Sales were also impacted by program completions and the sale of County of San Diego outsource contract, which had quarterly sales of $32 million in last year's third quarter. IS also continues to be impacted by the fiscal 2011 continuing resolutions and budget disruptions, which reduced funding for existing programs. As our shortest cycle business, budget reductions impact IS sooner than in some of the other areas. Despite lower sales, IS operating income for the quarter was relatively stable and operating margin rate expanded 70 basis points. The improvement is due to better performance in civil systems, including the benefit of the sale of the County of San Diego contract. Based on year-to-date results, I now see IS sales of about $8 billion, with an operating margin rate in the low 9% range. IS ended the quarter with a total backlog of $10.5 billion, reflecting new awards at $2.6 billion and a book-to-bill of just over 130%.

Moving to Technical Services, third quarter sales declined 22%, primarily due to the reduced participation in the Nevada National Security Site joint venture, which last year represented sales of $163 million. Operating income in Technical Services was comparable to last year and operating margin rate increased 170 basis points, principally due to the change in the joint venture participation. Based on year-to-date results, we expect TS sales of about $2.6 billion, with an operating margin rate of about 8% for the year. Technical Services ended the quarter with a total backlog at $3.5 billion, including new awards of $861 million and a book-to-bill ratio of about 125%. For the company, based on the strength of year-to-date results, we now expect a segment operating margin rate in the low 11% range and a total operating margin rate in the high 11% range. The increase in total operating margin rate, reflects the operational improvements we achieved to date and assumption of about $200 million for unallocated corporate expenses and some potential risk items.

Turning to cash, through nine months, cash provided by continuing operations before discretionary pension contributions is approximately $1.4 billion, and free cash flow before discretionary pension contributions is about $1 billion. So, based on our year-to-date results, we are on track for our cash guidance for the year. As Wes mentioned, we have increased our guidance for 2011 earnings per share from continuing operations to a range of $6.95 to $7.05 on a per-share basis. As Slide 4 indicates, our increased earnings per share guidance reflects an additional $0.10 to $0.15 for improved operating performance and $0.10 for lower diluted share count. I now see a reduction in weighted average shares outstanding for the year as slightly more than 6%.

I know many of you are focused on pension trends for 2012, so I wanted to provide an update in this area. Assuming our current discount rate and expected long-term rate of return on planned assets of 8.5%, as well as a host of other assumptions on mortality, wage increases, et cetera, 2012 net FAS/CAS pension adjustment would be comparable to this year's income of about approximately $400 million. Year-to-date through last Friday, estimated planned asset returns are slightly more than 5%. And as we have discussed last quarter, every 100 basis point difference from our 8.5% expected long-term rate of return represents approximately $35 million of FAS expense. And for the discount rate, every 25 basis points variance is about $65 million of FAS expense.

Obviously, we don't know exactly where interest rates will end the year but if I were setting the discount rate today, my cursory look would suggest a decrease in the range of 25 to maybe 50 basis points from our current rate of 5.75%. We continue to be very focused on managing the business for superior execution and strong cash generation while effectively deploying cash to create shareholder value. Included obviously, is investing in our business, distributing cash to shareholders in the form of share repurchases and dividends and managing the balance sheet.

Again, I'd like to reiterate that year-to-date, we distributed approximately $2 billion to shareholders through share repurchases and dividends, and at the end of the quarter, we had $2.4 billion remaining on our share repurchase authorization. On the balance sheet side, we will continue to monitor our pension plan investment performance and cash flow forecast to gauge whether or not we should make another discretionary pension contribution either or later this year or maybe even early next year.

So in conclusion, we are pleased with this quarter's results, especially the performance from our businesses, and we remain focused on generating value through portfolio optimization, performance and effective cash deployment.

Steve, with that overview, I think we're ready for some Q&A.

Stephen C. Movius

Thanks, Jim. In the interest of providing everyone an opportunity to ask a question, we ask that you limit yourself to one question and one brief follow-on.

Now, Anne, we're ready to take our first question.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Howard Rubel with Jefferies.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

Wes, you've been pretty good at anticipating a bunch of these changes and while you talk about some of your businesses having some growth opportunity, how would you characterize really the potential to show revenue growth over the next couple of years?

Wesley G. Bush

Well, it's certainly going to be a more challenging environment. And so let me give you a little bit of a flavor staring into 2012 as best we can. And again, we're not providing 2012 guidance on this call. So this is more in the category of flavoring. I would say beyond that, we're just going to have to continue to see how the budget environment shapes up as we go forward. But I would characterize it this way. Based on what we know today about 2012 budgets, the budgets appear to be heading towards, I would say, sort of a flat outcome relative to 2011. In terms of translating that into us, we would expect slightly reduced sales in a flattish environment due to the continuing impacts of some of the decisions that we've made. And these are proactive decisions we've taken on. One, the set of portfolio shaping actions that we've been talking about now for some time, as well as what Jim mentioned, the change in our approach to accounting on F-35 moving over the units for deliveries. So when we put those two things together, that represents in the range of $450 million to $500 million of downward pressure on our top line for next year. But I have to add, there can be additional changes in the budget environment, whether as a result of sequestration or other budget outcomes. And even though technically, those things are targeted to cause changes that would commence out in the 2013 timeframe. We know from observing our customer behaviors, over the course of this year that those changes would likely translate into customer actions in 2012. So even though I would characterize the 2012 budget environment as being, from what we can tell right now, rather flattish, it all depends on what happens over these coming months with a lot of the budget debate that's going on. I am encouraged just to balance that out a little bit, very encouraged by the strong statements that we're seeing from the national leadership, both Secretary of Defense and others in the administration, as well as a number of critical Congressional members who are calling for the preservation of a robust national security spending profile. So that's on the encouraging side of the equation. But realistically, we, like most others in our industry, are preparing for a range of outcomes to make sure that we stay competitive and that we're positioned to create value, irrespective of which way we see this go. There are meaningful opportunities out there. And as I went through the perspective on our portfolio, unmanned, cyber, C4ISR and logistics and all of those areas, we see priorities for customer investment. The question is going to be how much capacity do they have to apply towards those priorities.

Howard A. Rubel - Jefferies & Company, Inc., Research Division

I see that and, I mean, you also seem to indicate that there is a number of international opportunities that are possible. Are any of these really close at hand or is this -- I mean as you sort of see it, I don't want to talk too much about 2012 either and get you there, but if you sort of look at it, you don't have a lot of holes to fill for '12. There's more a potential for opportunity. Is that the way to think about it?

Wesley G. Bush

There's always a balance between the negative budget pressures as well again some of the other opportunities. International is an interesting area. I've learned a long time ago never try and project the timing on international awards. There's so many variables involved there. But there are some very substantial international opportunities on the horizon. The unmanned -- interest in our unmanned capabilities just continues to grow. And it will take a little bit of time for all of the policy decisions to be sorted out and the exact decisions on who can buy what. But I see that as a very meaningful set of opportunities for us. And just more broadly, in the C4ISR profile, I also see some very meaningful opportunities for us around the globe in that arena as well. So yes, international will be an important part of our perspective as we think about managing our portfolio going forward. Projecting the timing is a little difficult.

Operator

Our next question comes from the line of George Shapiro with Access 342.

George Shapiro - Citi

The question I had was this one general one and one follow-up. If the sales next year will be down a little bit, the book-to-bill all being well above 1 would imply that the duration of that what's being booked now is somewhat longer and that what would be the reconciliation of those two comments?

Wesley G. Bush

Well, we'll have to see how that actually plays out. What I indicated was some pressure on our top line for next year in terms of the ongoing effects of the portfolio decisions, as well as the accounting change on F-35. I want to be careful in not giving guidance for next year. We'll think about doing that as we have our call at the end of the fourth quarter. But your observation is a good one, George. Book-to-bill was strong this quarter. I think our backlog is holding up nicely and a lot of that is longer-term work. But it depends on which of the sectors in the company that we're talking about. AS is usually the longer-term cycle on awards, whereas IS and certainly TS are much shorter and ES is somewhere in the middle.

George Shapiro - Citi

And then just one for Jim. In the aerospace sector, you mentioned there's an unfavorable performance adjustment for a space program. If you could just quantify that a little bit, and then in electronics, you gave the number for the Flat Sequencing System but you also said there was some positive adjustments, so kind of what is the overall net-net effect in the electronics area?

James F. Palmer

In aerospace, the adjustment on the space program was about $18 million negative, an adjustment to change our booking assumption related to future on orbit fees. And then in electronics, yes, the $25 million adjustment for the dispute around the domestic postal program. But that was partially offset by positive adjustments, more than fully offset actually, by $17 million of the cost performance achievement on the SBR's program, as well as a $14 million international radar performance improvement. Net-net, ES had positive performance adjustments, including those 3 items, as well as some other smaller items as well.

Operator

Our next question comes from the line of Doug Harned with Sanford Bernstein.

Douglas S. Harned - Sanford C. Bernstein & Co., LLC., Research Division

I'm interested in Information Systems and you've got a very good backlog there, now this quarter. Your margins have been strong. When you look out, this is an area, it's shorter cycle. I think there are a lot of concerns about the federal IT budget environment and there appear to be a lot of competitors trying to move after new starts. What are you seeing, when you look forward, both in terms of the competitive environment and in just the general margin and earnings trajectory that one might reasonably expect?

Wesley G. Bush

Doug, let me give you a little bit of a flavor on the environment. If we look at the top line trajectory in IS over the course of this year, it's pretty much in line with what we're seeing across the market. Interestingly, if you dive into it a little bit, we have 3 major components of IS. We have the Intel business, the defense business and the Civil business. Intel and Civil are essentially flat over the course of the year, taking into account, as Jim mentioned in his remarks, the sale of the County of San Diego contract. The decline that we've seen has been primarily in defense. And when you analyze what's happening there, it is essentially pretty much across the board, a very broad array of program activities, where we're seeing lower funding levels driven by the customer's behavior as they're dealing with the complexities of their budget environment and all of the challenges that those customers are dealing with. So I think it's important to understand where we're seeing the effect and how that effect is manifesting. This is a market where there are a lot of competitors. When IS goes to market, it goes to market often times against four or five competitors. So there's a lot of competition. It is a market with a lot of variation as well in terms of how the products and services are offered. We tend to position towards the higher engineering content side of that marketplace. And we've got some good competitors out there. But we continue to see it as an attractive market. There is a continuing need on the side of the government, both the DoD and the intelligence community and the civil community to modernize the systems when it comes to Cybersecurity, to better protect the systems. And overtime, to actually put the government in a position of saving money by having more modernized and efficient IT systems. So it's a meaningful market but certainly a lot of competition.

Douglas S. Harned - Sanford C. Bernstein & Co., LLC., Research Division

Are you seeing margin pressure when you look forward with this higher level of competition?

Wesley G. Bush

We've given a view that I think we continue to see as the right view that a margin rate of around 9% in that business is sustainable. And I haven't seen anything that would cause us to change that outlook.

James F. Palmer

So, I guess I might -- I would add that if I look at our information services business, I characterize it in 2 broad categories, maybe 30%, 35%, 40%, that kind of range is services. The balance, let's call it 60%, is much more in software development integration, hardware integration, kind of product, if you will, product development. Clearly, I think we're seeing greater pressure on the services side, potentially. It's always been characterized by a significant number of competitors, and so that's the nature of the business, basically.

Operator

Our next question comes from the line of Myles Walton with Deutsche Bank.

Myles A. Walton - Deutsche Bank AG, Research Division

First of all, just more of clarification, Jim, in reconciling the discount rate, 25 to 50 basis points would be where you've snapped the line today. And I guess I was just trying to reconcile that with 100 basis point drop and the AA corporate and kind of what some of the other industrial companies are looking for, more in the 75 to 100 basis point area. Any thoughts there?

James F. Palmer

Myles, our discount rate is developed based on AA bond portfolio, exactly matched to the maturities of our pension liabilities. And so when we have done that in the past, the kind of -- and using that model at today's point, that gives us roughly 25 to 50 basis points reduction in discount rate. And at this point, it's almost meaningless because as you know, we set the rate at the end of the year. But snapping the line as of September 30, we were looking at about a 25 to 50 basis points decline.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. Fair enough. The real question is on the F-35. Lockheed is talking about the expenditure before contracts, essentially on the Lot 5. And I know, for you guys, Lot 4, I think, price point, I'm not sure you've finalized that. Can you give us an update on where you are with both Lot 4 and Lot 5 in terms of desensitizing your pricing. And also if there's any readthrough implications for you building off of contractor or pre-producing before contract is offered?

James F. Palmer

Let me take the last piece first. On LRIP 5, we have, at this point, I characterize as a $50 million exposure, if the program were to be terminated for some reason at this point in time. So it's something that we're mindful of, thoughtful of. But I think that we'll continue to monitor this as we go through time but it's a really important program, as you know, for our customers and we just got to come through the negotiations around the contract at the prime level and then we'll get our negotiations, I think, then shortly after that completed as well. On LRIP 4, we continue to have conversations. I think we're pretty well close. We don't have a final deal as yet but continue to work towards the deal.

Wesley G. Bush

And then Myles, this is Wes. Let me add on LRIP 5. It is really important that this contract gets funded, in terms of keeping this pro-bail [ph] production process on track to enable industry and the broad supply chain that supports the industry to enable us to continue to work on affordability. So there is a direct connection between affordability and getting this thing funded. And I know that everyone is working hard on that. We're working to support the process as best we can. But that is a key factor to keep in mind relative to this program. Getting LRIP 5 funded is a critical next step.

Myles A. Walton - Deutsche Bank AG, Research Division

Is there any type of -- I don't know once they drop-dead date, but I mean is it just [ph] that gets more painful the further on you go and there's no real drop-dead date though?

Wesley G. Bush

I think everyone has to think through where we all stand on this. And the position that I would say broadly industry is taking is we always work with our customer. Our customers are under great duress right now and we're working hard with our customer. But we're not in the business of financing these programs. So there comes a limit in everyone's capacity to deal with that. So it's something that I would say that there's strong alignment on across the industry and we're working as hard as we can to be supportive of the program but we recognize that we've got to get this thing funded.

Operator

Our next question comes from the line of Joseph Nadol with JPMorgan.

Joseph Nadol - JP Morgan Chase & Co, Research Division

Nice margin performance again this quarter, and I wanted to dig into that a little bit from a high level, just looking at the segment margins. It seems that Jim, a couple of the revenue points that you pointed out in terms of revenue pressure also are probably helping lift your margins, and, of course, you have good performance as well I'm sure, but de-emphasizing the non-core businesses, those are certainly lower margin. And then the budget pressure, the new start revenue that is not coming in presumably would've been lower margin revenue. So is there a way to quantify maybe of the 90 bps improvement year-on-year for the quarter or the 110 year-to-date, how much of that is maybe due to those issues? And then really, what I'm looking at is going forward, if you think about your segment margins next year, do you think that these levels are sustainable or do you think that the mix might provide a little bit of pressure as it normalizes?

James F. Palmer

As Wes said, and I want to reiterate, we're not providing guidance for 2012 at this point. But at the same time, we have commented a number of times that our long-term margin rate objectives for each of the four segments, we believe, are representative of where those businesses ought to be performing over a long period of time. We feel comfortable about that even in today's environment. As far as trying to quantify how much of this year's margin performance improvement is mix or other factors, it's very, very difficult to do. Clearly, the organization had had an increased focus over the last couple of years, frankly, on strong execution. As you know, we've been very mindful of being prudent about the types of contracts we take, getting contract structured appropriately, structured to reflect risk inherent in the type of work that we're performing, and ultimately making sure that we have a management team that is strong and focused on delivering the product, as well as the margins that were negotiated in the contract. So I don't think I can really break it down into the elements that you're looking for.

Joseph Nadol - JP Morgan Chase & Co, Research Division

It's a tough question, I know. Just as a follow-up on your pension comments, Jim, in terms of the flat FAS/CAS, what is your assumption for each of the components, for FAS and for CAS? And I'm specifically trying to divine your year CAS expectations?

James F. Palmer

Actually, I don't have that number with me. But as I recall, the CAS cost accounting number doesn't move much on a year-over-year basis from '11 to '12. I'd have to get back to you on the actual numbers. But as I recall, there's not much improvement change in the cost accounting pension expense from '11 to '12.

Operator

Our next question comes from the line of Carter Copeland with Barclays Capital.

Carter Copeland - Barclays Capital, Research Division

I want to go back to one of your growth areas and you talked about on cyber, and General Clapper was commenting a week or two ago about the pressure that we may see on IC budgets and the intelligence community, participating in the budget cuts and deficit reduction, and I wanted to know, I mean this is a part of your business I know that's tough to talk about it, but as you think about that growth avenue, in the context of that sort of commentary, have your expectations there changed at all? What are you seeing there? How are you thinking about that? Is there information in there that we should take notice of?

Wesley G. Bush

The way characterize it just fairly broadly is kind of in 2 pieces. One Intel and then more broadly. On Intel, clearly every part of the federal government is going to have to participate in the efforts to work on the budget deficits. And I think Mr. Clapper's statements were reflective of that. That said, within each of the budget areas, there are going to be priorities and we continue to see cyber as a priority, a very high priority because of just the ever-growing recognition of the threat and the ever-growing magnitude of the threat. So within Intel, we continue to see Cyber as a priority. But the second perspective is the broader perspective, which is Cyber, for many years, had been something that had been largely focused in the Intel and defense communities as the primary concerns around what the threats might be capable of doing with respect to challenging the nation's capabilities. That is no longer the case. Clearly, Intel and defense continue to be very, very concerned and very focused on Cyber. But that concern has now expanded across the government and even beyond government. And as I think I mentioned in my opening remarks, as we see the concerns migrate from, if you will, the .mil domain into the .gov domain, the need for cyber security and cyber protection is continuing to expand. So we think this is an important part of our overall portfolio and we do see it as high on the priority list in just about any scenario going forward.

Carter Copeland - Barclays Capital, Research Division

So if the IC budget needs to contract but cyber doesn't, what is it that has to lose? I mean it seems like a zero sum game to me?

Wesley G. Bush

Well, clearly, there will be other aspects of it and I really wouldn't want to go into the other elements of the Intelligence Community budget. But it will be a portfolio balancing process that the Intelligence Community has to go through to, just as the DoD is going through.

Operator

Our next question comes from the line of Cai Von Rumohr with Cowen and Company.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Just two follow ups in terms of risk issues. Have you completed your contract with Boeing on the F-18? And secondly, given that you took a loss on a postal contract in this quarter, are we going to have to see any more losses to get out of this business?

James F. Palmer

Let me take the last one first. Obviously, if we thought there were any more losses that we had to take, we would've booked them in the quarter. Obviously, every quarter address the situation. So it's -- something changes that will be reflected in that quarter's results, but kind of based on what we know, we got it. If the environment changes, we will address it. On the F-18 multiyear contract, we continue to have negotiations or conversations with Boeing around that contract. Again, we're making progress. But I would characterize it as signed, sealed and delivered at this point.

Cai Von Rumohr - Cowen and Company, LLC, Research Division

And lastly, do you have any other contracts? You've mentioned F-35 and F-18, any other contracts where you are a subcontractor where you're kind of working without a finalized contract? I mean obviously not a $10 million job. But any other large ones of substance?

James F. Palmer

I don't think so. They key -- I think, what you're really trying to get at is where you don't have funding...

Cai Von Rumohr - Cowen and Company, LLC, Research Division

Right.

James F. Palmer

So, for example, just because we don't have a contract on F-18, we have funding and are being paid in accordance with normal practices for costs being incurred. So other than that, the comments around the F-35 Lot 5, I can't think of any substantial dollars or contracts that we really have at risk associated with the work that we've already performed.

Operator

Our next question comes from the line of Rob Spingarn of Crédit Suisse.

Robert Spingarn - Crédit Suisse AG, Research Division

Regarding the bookings, this goes back to George's question and, Wes, I think you did acknowledge that the -- very strong quarter here, of course. But the earlier quarters were a little lighter. What are you thinking for December? Was this driven by the year end for the federal budget?

Wesley G. Bush

We generally don't guide on awards and so I wouldn't want to get into the habit of doing that. Third quarter is often times a stronger awards quarter, particularly in IS, where we've got a little bit more of the short-term stuff. However, I would say, this year has not been a typical year by any stretch of the imagination with the effects of the continuing resolutions, both last year, the 2011 CR and the prospect of a longer CR here in 2012. So I wouldn't try and use my average year comparisons for this year because things have been quite a bit in flux. So we'll see how we do in the fourth quarter. We are working that aggressively, working it hard, of course, to make sure that our backlog continues to be a healthy position for the company. But when I look at how we're doing competitively, which is kind of how it comes out ultimately, I'm pleased with how we're doing competitively. I think we're doing quite a good job in capturing the work that we're going after, when I look at it in a broad sense across the company. And if we can continue to do that, I think we'll do just fine.

Robert Spingarn - Crédit Suisse AG, Research Division

Okay. And then just on a cash return to shareholder basis, you've been very good about buying back stock and using your portfolio-shaping opportunities to do that and a long history there. Are you thinking at all about shifting the stock repurchase alignment against the dividend and perhaps favoring the dividend going forward? There seems to be a trend there.

James F. Palmer

Rob, we continued to, as I said with the $2.4 billion remaining authorization for share repurchases, we liked the balanced approach that we've had over the, frankly, since we started share repurchases in 2003. And I'd just point out that since 2003, through the end of the third quarter, cash return to shareholders in the form of share repurchases and dividends is, from round numbers, 100% of free cash flow on an aggregate basis through that period of time. I don't see much change in continuing to emphasize both share repurchases and dividends. We obviously view dividends as very important, and as a long-term commitment to our shareholders. So we look at both the competitive payout ratios, as well as using other cash to be able to purchase the stock when prices are we find attractive.

Robert Spingarn - Crédit Suisse AG, Research Division

But would you see any value, perhaps, in having a higher dividend yield given what some of your peers have done in order to send that message on your long-term confidence?

James F. Palmer

You mentioned yield. I am not a yield-focused guy. I can get yield up by having a stock price decline. I am a payout-focused guy. We are, as a company, think about it in that term and we think that we have competitive payout ratios.

Operator

Our next question comes from the line of Heidi Wood with Morgan Stanley.

Heidi R. Wood - Morgan Stanley, Research Division

Wes, I want to turn back to this F-35 issue and explore it just a little bit more. And I admit I'm a little confused by your comments about being encouraged by strong statements from leaders. Could we share a thought on record talking about being willing to break glass in the industry, and going through this Should-Cost review. Should we take this to mean that the Should-Cost review is going to be confined to the F-35 or I guess I'm just a little worried that this is a canary in the coal mine.

Wesley G. Bush

My commentary with respect to strong statements by leaders with respect to the robustness of national security spending and the view that the Secretary of Defense, and as I think I mentioned others in the administration, as well as some senior leaders on Capitol Hill, have been very public in expressing over these last number of weeks that it's imperative that even though we've got to all work hard in deficit reduction, we have to protect the national security. And I see that as very, very encouraging. With respect to the implementation of the variety of initiatives under way in the Pentagon, I do think this Should-Cost methodology is a broad methodology that is intended to be applied in a variety of different circumstances. I wouldn't know how to project what the full breadth of that application might be. But it's something that I do think we'll see an increasing amount. It remains to be seen what that translates into for contract outcomes. Obviously, the government, the department needs a set of methodologies to make its determination of value and cost and contracts. But there's always somebody else at the table in this industry. The industry also has to make its determination of what we're willing to do, how far we're willing to go, in terms of the risk side of the equation; and what reasonable profitability opportunity needs to be on those contracts. So it's not one-sided. It's two-sided. And we have to be able to work hard to get our way through this. So I would say there is probably a little bit more tension in the system right now, around how all this is going to work, what the real outcomes are going to be. But we're going to have to pop through it.

Heidi R. Wood - Morgan Stanley, Research Division

All right, and then a follow-up. You and I have had discussions about how you're shaping Northrop and keeping what you see ahead, you've been obviously divesting in a thoughtful and disciplined way. Should we expect to see, as we look ahead, a pickup in M&A activity?

Wesley G. Bush

It will always, for us, come down to value creation. And I will say in watching some of the recent M&A activity, it's been a little hard for me to figure out how with multiples getting paid, we actually generate a lot of value. And so when we're looking at really high multiple, transaction multiples out there, it's probably not the first place we go for value creation, but we do look. We are engaged. We have not closed down our M&A department. It's an important part of the long-term vitality of any organization to be engaged in bringing in capabilities. I've said a number of times and I still am on the same mind that I don't see any big gaping holes in our portfolio today. So there's not a strategic urgency that we're feeling around. We've got to go by this capability or we got to go by that capability. But we are thinking about it in a broad way, thinking about the future of the industry, and where the industry may shape out here in a different environment. And I think you should expect us to be thoughtful but disciplined as we get into this process.

Heidi R. Wood - Morgan Stanley, Research Division

All right, great. Then if not, then we'd see more focus on share repo and dividends as usual?

Wesley G. Bush

We've had a long track record of doing that.

Operator

Our next question comes from the line of Sam Pearlstein with Wells Fargo.

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

Just on the use of cash, Jim you had mentioned thinking about a discretionary pension payment in the fourth quarter of this year into next year. Just how do you weigh that just because obviously with the pressures you're going to see from the FAS side going into next year, how do you weigh that relative to buybacks or dividends?

James F. Palmer

As I mentioned, I will look at both investment performance in the plan and then our cash flow expected results for the year, as well as into next year. As you know, our history in the pension plan has been to generate a nice returns in excess of our long-term rate of return of 8.5%. And so pension contributions, in which you get a tax deduction and then generate those kind of returns that we've had in a historical basis is a very, very good use of cash. Cash on cash returns on a historical basis in excess of 12%. So the balance of both wanting to make sure that our plan is very well-funded, returning cash to shareholders, as I mentioned. And so it's really a balancing activity around the effective use or deployment of our cash.

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

And then just in general, it sounds like what you've been saying is that the areas that impacted you in the second quarter, in terms of a slow recovery from the end of the continuing resolution, that the customer behavior really has not changed over the course of the third quarter. Or has it actually gotten a little bit worse in terms of the time it takes for them to give you task orders, et cetera?

James F. Palmer

I would characterize it as an overall about the same. In some areas, it's a little bit better. In some areas, others, as I mentioned in my comments, we thought that there may have been some additional funding on certain programs that would've allowed us to offset some of the other declines that we had anticipated, for example, the F-35 change in revenue recognition model. So on an overall basis, I'd characterize it as about the same.

Samuel J. Pearlstein - Wells Fargo Securities, LLC, Research Division

One last question is for Wes or either of you, are there any key orders or bigger orders that we should be thinking about, like an LRIP 4, F-35 stands out when those come in? But is there anything else that we should be thinking about that's big over the next six months or so?

Wesley G. Bush

There's a whole variety of things that are out there. No one in particular is make or break. But I've mentioned a few of them already. Maybe just to give you a little bit of a flavor across some of the businesses. In AS, unmanned continues to be an important area for us, both domestically and increasingly international. The UAE, the airborne surveillance program, is an important in AS. And over the longer term, U-class is a program that we're certainly putting a lot of attention and focus on, but that's a little bit longer term. In ES, I would point out the CIRCM program, as the Army IRCM program that's outcoming. The Air Force is working on upgrades to F-16. I think that's going to be an important part of it and the Navy's pursuing new class of radar and the call it air and missile defense radar, AMDR. That's an important side of future opportunities there. In IS, CANES on the Navy side is coming in the not-too-distant future, I believe and I've already talked a lot about the cyber work and the different dimensions of that. Ground Combat Vehicle, where we're partnered with BAE systems, is another very important program. We'll see how that matures and what the timing of that might eventually turn out to be. And technical services has a whole variety of both sustainment and upgrade activities, that it is out competing in the not too distant future. The whole company is actively engaged in opportunities and pursuing them aggressively.

Stephen C. Movius

Anne, this is Steve. I think we have time for one more question.

Operator

Our last question comes from the line of David Strauss with UBS.

David E. Strauss - UBS Investment Bank, Research Division

Wes, you described your exposure to OCO at around 3%. Does that reflect the $200 million impact you've already seen this year or is that prior to that? And the 3% or so you do have left, how do you expect that to kind of come down here with obviously what's going on in Iraq and the drawdown in Afghanistan?

Wesley G. Bush

That is the overall 3% is kind of 2 different pieces. One piece of it has been BACN. BACN was an important component of the OCO business. And how BACN transitions overtime, does it find its way into the base budget or not, we'll have to see. It's been very, very successful in theater and there has been a growing view of its longer-term importance. So hard to tell how that piece of it goes. The other pieces of it are lots of different programs. We talked on the second quarter about VIS, it was an important part of it. There was a huge push over the course of last year on VIS to get it deployed in the theater on all kinds of different vehicles. So this year's sales have come down substantially on VIS. But the remainder of that is just a whole variety of programs that are providing individual pieces. LAIRCM has also benefited from some of the OCO funding. So it's a little bit hard to tell with the planning in Afghanistan exactly which pieces of it come out at what time. But again, it's a fairly distributed set of elements across our portfolio.

David E. Strauss - UBS Investment Bank, Research Division

As a follow-up, based on your guidance, you're calling for a lower Q4 in terms of earnings. I think this might partially have to do with higher corporate expense. Jim, maybe if you can just give some color around that and maybe talk longer-term, the outlook for corporate. It seems to keep coming in lower than what you're guiding to.

James F. Palmer

David, I know in the fourth quarter that we've taken some actions already in the fourth quarter, some headcount reduction actions. And so that will be somewhat of a drag in the fourth quarter. And there are a couple of things in the corporate and allocated world that at least have a potential to occur in the fourth quarter, so all of those have been considered or factored into our thinking around the fourth quarter results.

Stephen C. Movius

And that concludes our Q&A. Wes, any final comments?

Wesley G. Bush

Yes. I guess just to summarize. I would say our strong third quarter results demonstrate that our continuing focus on performance, portfolio optimization and cash deployment to benefit our shareholders is creating value for our company and positioning us well for what is going to be a more challenging environment. So thanks again, everyone, for joining us today and for your continuing interest in our company.

Operator

Ladies and gentlemen, we thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Have a good day.

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