Northrop Grumman's (NOC) CEO Wes Bush on Q1 2016 Results - Earnings Call Transcript

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Northrop Grumman Corp. (NYSE:NOC)

Q1 2016 Earnings Conference Call

April 27, 2016 12:00 ET

Executives

Steve Movius - VP, IR & Treasurer

Wes Bush - Chairman, President & CEO

Ken Bedingfield - VP & CFO

Analysts

Noah Poponak - Goldman Sachs

Carter Copeland - Barclays Capital

Howard Rubel - Jefferies

Jason Gursky - Citigroup

Myles Walton - Deutsche Bank

David Strauss - UBS

Doug Harned - Bernstein

Seth Seifman - JPMorgan

Robert Stallard - RBC Capital Markets

Cai von Rumohr - Cowen & Company

Sam Pearlstein - Wells Fargo Securities

Seth Seifman - JPMorgan

Hunter Keay - Wolfe Research

Robert Spingarn - Credit Suisse

Ron Epstein - Bank of America, Merrill Lynch

Operator

Good day, ladies and gentlemen, and welcome to Northrop Grumman's First Quarter 2016 Conference Call. Today's call is being recorded. My name is Robin and I will be your operator today. At this time, all participants are in listen-only mode. [Operator Instructions]

I would now like to turn the call over to your host, Mr. Steve Movius, Treasurer and Vice President, Investor Relations. Mr. Movius, please proceed.

Steve Movius

Thanks Robin, and welcome to Northrop Grumman's First Quarter 2016 Conference Call. In addition to filing our first quarter 10-Q this morning, we also filed a form 8-K to recap the presentation of our consolidated financial statements for years 2013 through 2015 and the disclosures in certain portions of our 2015 10-K to reflect the changes in the company's organizational structure and reportable segments. We've also recast certain 2015 quarterly information as provided in schedule four of today's earnings release.

Before we start, please understand that matters discussed on today's call constitute forward-looking statements pursuant to Safe Harbor provisions of Federal Securities laws. Forward-looking statements involve risks and uncertainties, which are detailed in today's press release and our SEC filings. These risk factors may cause actual company results to differ materially. Matters discussed on today's call may also include non-GAAP financial measures that are reconciled in the earnings release. On our call today is our Chairman, CEO and President Wes Bush; and Ken Bedingfield, our CFO.

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

Wes Bush

Thanks Steve. Good afternoon, everyone and thanks for joining us today. This was a good quarter and a strong start for the year. So I want to thank our employees for their unwavering focus on performance. Our team continues to execute well and position the company to achieve profitable growth over the long term.

In the first quarter under our realign structure, all three businesses delivered strong results. To remind everyone, we undertook this realignment to better-focus our innovation and affordability efforts to provide our customers enhanced mission capability at a reduced cost. To find more effectively aligning and aggregating our products and services businesses, we enabled greater operational synergy and enhanced our ability to develop, produce, sustain and upgrade our products over their entire life cycle.

Sales for the quarter were comparable to last year at $6 billion. First quarter segment operating margin rate was 11.8% and supports our outlook for the year. Before the tax benefit, first quarter earnings per share would have been $2.59, a 7.5% increase over last year's first quarter. Including the tax benefit, earnings per share totaled $3.03. Cash from operations was the use of $60 million, substantially better than last year's first quarter. Free cash flow was the use of $358 million and includes capital spending of $298 million.

The first priority of our deployment strategy continues to be investing in our businesses to position the company for the future. We continue to return cash to shareholders. During the quarter, we repurchased $1.5 million shares. This quarter's share, we purchased pace, supports our guidance of the 6% reduction in weighted average diluted share count this year. At the end of the first quarter, approximately $4 billion remained on our share repurchase authorization.

For the year, we continue to expect sales will range between $23.5 billion and $24 billion with free-cash flow of $1.5 billion to $1.8 billion which reflects strong cash from operations and investments for the future. As a result of the tax benefit and first quarter performance, we are raising our 2016 EPS guidance to a range of $10.40 to $10.70. First is our prior guidance range of $9.90 to $10.20.

In addition to this quarter's solid financial results, I'd also like to highlight some operational achievements. At Mission Systems, our Saber Radar started flight testing for the US F-16 modernization program. Saber brings fifth generation radar capability to the F-16 by leveraging hardware and software commonality between our F-22 and F-35 AS Radars. AMS will begin delivering Saber for international F-16 customers later this year. Also during the quarter, our BCN high altitude airborne communications gateway achieved a 100,000 combat flying hours and continues to provide critical communications capabilities by translating and distributing imagery, video, voice and data to enhance communications and awareness on the ground and in the air.

At Aerospace Systems, we successfully flew a Cyrus 2 Sensor on a Global Hawk, the first time this sensor has been demonstrated on a high altitude unmanned aircraft. Later this year, we expect to fly additional sensors on Global Hawk and we expect that Global Hawk will demonstrate its flexibility for supporting a wide variety of U.S. Air Force operational requirements. Triton, the maritime variant of Global Hawk continued to make good progress in its operational assessments this quarter. We look forward to a positive milestone sea decision that would transition Triton to low-rate initial production later this year.

The highlight during the quarter was getting back to work on the B-21 program. We're pleased at the GAO confirmed that the Air Force conducted an extremely thorough selection process and chose the most capable and affordable solution. The next generation Bomber is critical of the national security. It will allow significant forced projection anywhere in the world in an anti-axis aerial denial environment. We are absolutely committed to outstanding execution on this program and we are off to a strong start.

Northrop Grumman is a technology-driven company. Our team is pursuing innovation and breakthrough technologies to support the world's most technologically advanced military. A successful partnership with our customers helps to ensure military superiority. This partnership requires innovation, affordability, investment and performance. Investment on our part through IRAD and capital spending is critical and performance on our part is equally important. We are increasing investment through IRAD and capital expenditures as our opportunities that has grown. And we are committed to delivering very good returns on these investments.

Over the past several years, we've demonstrated that as a company, we can't perform during a challenging down cycle. That focus is even more important as we began work on important new development programs and continue to position the company for profitable growth over the long term.

To conclude, it was a good quarter and a solid start to 2016. Our value proposition remains the same: drive strong sustainable performance, generate cash and effectively deploy that cash. We continue to believe this is the right strategy and that it positioned us for continued long term sustainable value creation for our shareholders, our customers and our employees.

Now I'll turn the call over to Ken for a more detailed discussion of our results and guidance. Ken?

Ken Bedingfield

Thanks, Wes, and good afternoon, everyone. I want to add my thanks to our team on their continued outstanding work. Today I'll briefly review our first quarter results and provide a little more detail on our 2016 guidance. But before I do, let me provide some more detail on our realignment. I'll start with Aerospace Systems.

The Azusa based military and civil space business formerly inherited to ES is now part of AS and the electronic attack business formerly in AS is now part of Mission Systems. AS continues to focus on demand aircraft, autonomous systems and space business areas. At Mission Systems, elements of our former information systems portfolio that were focused on sophisticated systems architecture and engineering including both advanced software and hardware capabilities are now combined with our former electronic systems portfolio. This creates a more integrated business to support development of new capabilities for our military and intelligence customers around the globe.

Within Mission Systems, we offer products and services in three major business areas: sensors and processing, cyber and ISR and advanced capabilities. Sensors and processing is the largest of the three and is focused on land and airborne radar, EW, C-2 and second efforts. Cyber and ISR encompasses a combination of work from the two legacy sectors including full spectrum cyber systems and ISR collection, processing and exploitation. Advanced capabilities provides integration and interoperability of net-enabled battle management, sensors, targeting and surveillance systems, air and missile defense, C-2 and global battle space awareness.

Technology services combines the service elements of our former information systems sector with the former technical services. The new TS includes our health IT work and a majority of our civil work. Technology services' primary focus is on life cycle support and modernization of systems and platforms as well as advanced training. The business areas of within TS are global logistics and modernization, advanced defense services and system modernization and services.

Turning to our financial results; our first quarter ETS included an $80 million or $0.44 per share tax benefit. We early-adopted an accounting standard update that requires recognition of excess tax benefits and efficiencies related to share base payments as either income tax expense or benefit in the TNL depending on whether the stock compensation awards best at, above, or below the grant price. In addition, the update requires these items now be presented in operating cash flow rather than as a financing item. Even before the benefit of the accounting update, we had a solid quarter.

Turning to the sectors; aerospace Systems sales rose 3% to approximately $2.6 billion due to higher volume for manned aircraft and autonomous systems. A manned aircraft, we continue to ramp up on our E2D program including production for Japan's first aircraft. Higher F-35 sales also contributed as we delivered 13 units this quarter versus nine in last year's first quarter. Increases on these programs were partially offset by lower volume for the D-2 as well as fewer FAA team deliveries and in the prior period. As expected, we delivered seven FAA teams this quarter versus nine in last year's first quarter.

Higher revenue autonomous systems included higher volume for Global Hawk and Triton. Global Hawk volume reflects the upgrade activities Wes mentioned earlier as well as production activity on Korea's Global Hawk. Triton volume continues to increase as we progress toward low-rate initial production. Space sales were comparable to the prior year period. Aerospace Systems operating income decline compared to last year's first quarter, an operating margin rate with 11.1%. First quarter operating income reflects lower margins on several manned aircraft programs with the primary driver being the timing of risk reductions.

For 2016, we continue to expect Aerospace sales in the low $10 billion range with a mid to high 11% margin rate. No change from prior guidance. Mission Systems' first quarter sales were comparable to the prior year at approximately $2.7 billion. Operating income increased 3% and operating margin rate expanded 40 basis points to 13.1%. Sales reflect lower volume for cyber and ISR programs, partially offset by higher volume for sensors and processing and advanced capabilities programs. For 2016, we continue to expect Mission Systems sales in the high $10 billion range with an operating margin rate in the mid to high 12% range. No change from prior guidance.

Technology services sales decline 4%, principally due to continued ramp-down on the ICBM program as well as lower volume for restricted programs. Operating income declined in-line with sales and operating margin rate was comparable to last year at 10.4%. For 2016, we continue to expect sales in a mid-$4 billion range with a margin rate of approximately 10%. No change from prior guidance.

As Wes mentioned, our segment operating margin rate for the quarter was 11.8%, which is a good start towards our full-year guidance of high 11% for the year. Total operating margin rate of 12.4% was strong and we continue to expect total operating margin rate of about 12% for the full year. Our net FAS/CAS adjustment is unchanged at $275 million for the year and we continue to expect unallocated corporate expenses of about $200 million.

As a result of the $80 million tax benefit, our effective tax rate declined to 17.8% for the quarter and for the full year, we now expect an effective tax rate of approximately 27%. Our updated 2016 earnings per share guidance of $10.40 to $10.70 reflects a $0.50 increase to the top and bottom of the range and continues to assume our weighted average diluted shares decline by approximately 6% to about $181 million shares.

We continue to expect 2016 free cash flow to range between $1.5 and $1.8 billion. Our free cash flow guidance anticipates capital spending of $700 million to $1 billion in 2016. First quarter capital expenditures totaled $298 million and include $159 million for the purchase of the building previously leased by Mission Systems. In addition to the building we purchased in the first quarter, we expect to close on another facility in the second quarter.

I'll conclude my remarks with a discussion on awards and backlog. During the first quarter of 2016, the company's total backlog increased and reflects higher backlog at Aerospace Systems and Mission Systems in a modest decline in backlog at technology services. The company recorded various awards during the quarter including a portion of the B-21 Long Range Strike Bomber Program. We intend to report backlog and awards on a full-year basis for the company and each sector in our 2016 annual report on Form 10-K. We also intend to provide qualitative information on a quarterly basis similar to this quarter's disclosure until year-end.

Before we begin Q&A, I would also remind everyone that beyond the statements in our prepared remarks, we have no additional information to share on the B21 award or the program in general. I think we're ready for Q&A. Steve?

Steve Movius

Thanks, Ken. As we open up the call for Q&A, we ask each participant to limit themselves to a single question. Robin?

Question-and-Answer Session

Operator

[Operator instructions]. Your first question comes from the line of Noah Poponak with Goldman Sachs.

Noah Poponak

Hi. Good afternoon, everyone.

Ken Bedingfield

Hey, Noah.

Noah Poponak

Wes and Ken, I wanted to try to ask about margins going forward and I just heard the directive on one part. So this is kind of a multi-one part that I'll try to wrap into one. But we get a lot of questions from investors about - we've seen all the new business wins and we think the top line can grow, but we hear concern that margins will go down because of all that new business. When I map it out, it seems pretty likely your F-35 business margins will improve. When I map out your own man business, it looks like margins can improve pretty significantly there because they're such a big mix shift to procurement from development and too international. So I think people kind of get concerned at the Bomber being a new large development program will be pretty dilutive to the margin.

But when I look at it because Bomber stays so much smaller than those other programs, total unmanned F-35 and some others for a while, I actually arrive at the total company having segment margin expansion pretty much every year for the next three to five years. I know you probably don't want to give specific annual guidance, but just directionally, is that in a scenario analysis? Am I missing anything with the margin trajectory?

Ken Bedingfield

Noah, great question and I wouldn't say that you're missing anything in terms of analysis of the fact that we've got a lot of moving parts. We do have a well-diversified portfolio and we've got some business - you're right - should be driving towards some higher margins. We have been realizing margins on F-35 that are below what we expect for a program at that level of maturity and we certainly expect as we move towards more mature production, that we would realize higher margins in that area. Autonomous Systems, we do see some international business that's moving into production as well as Triton hopefully moving out of development and into LRIP. So we would expect to the potential first on higher margins there.

That being said, we do have a fair amount of development work that we're taking on whether that's B-21 or some of the other strategic items that Wes mentioned - whether that's Saber, or SEWIP, or G/ATOR or others. In some respects, the question is what's going to move first in a web velocity among those various moving parts? I would say that overall, certainly some pressures on margin rates as development programs grow, but as you mention, we do have more mature production that's also going to be growing in terms of dollars. The other one I probably should have mentioned is E-2 that's now into multi-year production.

So we'll continue to work on it. I see it as being range-bound into a reasonable range. We have the opportunity to continue to perform and we also need to work to try to offset the pressure that will come from the development margins.

Operator

Your next question comes from the line of Doug Harned, Bernstein.

Doug Harned

Yes, thank you.

Wes Bush

Hey, Doug. Good afternoon.

Doug Harned

I'm interested in Mission Systems. You made the comment that you're seeing this quarter lower sales for ISR in cyber, higher for sensors, but if you look forward and you look at the pieces of that business, can you talk about where you see the growth trends? Because that doesn't sound like its representative of where this business is really headed over the next few years. Could you comment on that?

Wes Bush

Doug, its Wes. Let me just give you a kind of sense of how I see things with respect to our Mission Systems business. Our strategy in putting the parts of the Legacy electronic systems and Legacy information systems, business together that we combined to create MS was precisely around - I think what you're getting to, which is growth - there's opportunity in that market space over the longer time by integrating those capabilities together in innovative ways that I think will help position us quite nicely to do exactly what our customer needs us to do, which is to give a more capability at lower cost.

When I think about the core product lines in there, the areas that I see as having really good growth opportunities, clearly communications, the work that we do in creating software define capabilities for communications is extensive and we're continuing to see a great demand in that area. Certainly combat avionics is a big part of the growth equation in MS. Cyber, as we've talked about for some time is another area that's growing well and I think you're all familiar with the fact that we have not only had a good IRCM business for some time, but last year with our capture of the crypto contract that added to our portfolio of opportunity in that countermeasures business.

All of those areas are I think examples of the types of businesses where we see really good growth prospects going forward with MS. Ken, was there anything you'd like to add on that?

Ken Bedingfield

I think you hit it on the head on that one, Wes. I think that's the right answer to the question.

Wes Bush

All right.

Operator

Your next question, from the line of Seth Seifman with JPMorgan.

Seth Siefman

Thanks very much and good morning.

Ken Bedingfield

Hi, Seth.

Seth Siefman

Hi. I just wanted to ask about the dividend. Based on what you've done in the past, it would seem that you guys have an increase coming up potentially on next month and part as a function of the rise in the share price, the yield is down to I think about 1.6% to 1.7%, and how you think about where you want that to be going forward?

Ken Bedingfield

Seth, thanks for the question. We do historically review our dividend for whether there will be an increase at the main meeting of the boards, so that is upcoming. I would say that we've had a history of dividend increases for a number of years and we will consider that between now and that meeting. I would just comment that in terms of chasing dividend yield, we don't make a practice of chasing yield. I would note that our yield is lower than some of our peers primarily because of stock price performance as opposed to dividend historical increases.

We tend to think of dividend in terms of a payout ratio and that payout ratio being pension-adjusted net earnings and we believe if you look at our dividend in that light, you'll see that we're in a competitive range within our peer group. That's the light in which we'll continue to analyze this for the foreseeable future.

Operator

And your next question is from the line of Robert Stallard with the Royal Bank of Canada.

Robert Stallard

Thanks so much. Good afternoon.

Ken Bedingfield

Hi, Rob.

Wes Bush

Hi, Rob.

Robert Stallard

A Bomber's question. First of all on the B-2, you know that it was a bit lower in Q1. Is this a trend or can we expect this program to remain steady going forward? And secondly on the B-21 - I know we're not allowed to ask you a question, but I'll try - have you had any indication from the Air Force that they will be easing up on the classified structure of this program? Thank you.

Ken Bedingfield

Rob, your first question on the B-2, I would say I do not believe the first quarter volume indicates a trend. This is one that has a number of aspects to the program and various pieces of business that run through there. So I think it's primarily just timing. Modernization more so has a bit more of fluctuation than the baseline maintenance and operations business. As far as the B-21, I wouldn't be able to comment. I think that's something we'd leave for the Air Force to determine income.

Operator

And your next question is from the line of Ron Epstein with Bank of America Merrill Lynch.

Ron Epstein

Yay! Good morning/afternoon, guys.

Ken Bedingfield

Hey, Ron.

Ron Epstein

It looks like in Mission Systems, you guys said that the volume in margins were down for cyber and ISR. It seems like the past few years, both of those areas were growth drivers for the segment. Is that decline sort of a quarterly thing, or are we seeing a shift in customer priority?

Wes Bush

I think it's important to be clear about what that was within that part of the business and I know it's a little bit difficult to track what's in the pieces quite yet, given that we're brand new in putting out a description of how we're categorizing the different elements of the business and I would direct you to look at the 8-K that just got filed to help better understand that. But the thing that was really driving that this quarter, the lower sales and the part of the business that we call cyber and ISR was actually a lower volume on the Counter-Narcoterrorism Technology Program, CNTPO, which is an IDIQ type of contract with different task quarters that's been sort of fluctuating up and down over the years.

So, I would not describe that in any way as a core part of the way we characterize cyber or our ISR activities. That happens to be a part of what got put into that portion of the business that we described with that label. So we don't see any negative trends at all in sort of the core cyber or ISR elements of our business. But CNTPO with respect to some of the IDIQ task force had some fluctuation that drove that outcome.

Operator

And your next question is from the line of Cai von Rumohr with Cowen and Company.

Cai von Rumohr

Yes. Thank you so much. Did I miss the backlog numbers? Are we going to get restated backlog numbers for your three new businesses?

Ken Bedingfield

Cai, just a comment on the backlog. We are presenting backlog on a quarterly basis at this point on a qualitative level by sector. So we did provide information that AS backlog is up, MS backlog is up and technology services is moderately down. I'd refer you to the 8-K for the details that are in there with respect to backlog.

Operator

And your next question is from Carter Copeland with Barclays.

Carter Copeland

Hey, good afternoon, Wes and Ken.

Wes Bush

Hi, Carter.

Carter Copeland

Just a clarification question. I noticed there was no B-21 disclosure in the AS comments. Is that due to the programs classification or because of its materiality? I guess just clarify that for us and then a higher level question for you, Wes, and it's about sort of managing growth and performance simultaneously. You got a lot of programs ramping and you got a lot of additional opportunities on the horizon, but clearly executing on the cost performance on several of these programs and none more so than the B-21 is huge.

So, I wondered if you might give us some insight into how you're thinking about how you managed that given the history of several of these programs and the importance to the customer of maintaining the cost targets that you've laid out there.

Wes Bush

Yes, Carter, thanks for the question. With respect to B-21, the disclosures are what they are. We've got the material and what we have released that we're going to be able to disclose on it. I really appreciate your question on growth and performance because it is a topic that we've been spending quite a bit of time on within our company and not just recently having one, a number of activities to something that we've been working hard to be prepared for a long period of time; and the actions that we've taken over the last several years with respect to our focus on execution performance on our programs, I think is serving us very well on that regard.

I know a lot of folks sort of look at the margin expansion that we had over the last few years and thought, “Well, that's just cost reduction.” Well, clearly cost discipline is an important part of it, but I will tell you the big driver for all of those margin expansions was actually better performance, better programmed execution and that discipline in the company has steadily been increasing and it is the focal point for just about every engagement we have with our leadership team in terms of the actions that we need to be taking collectively to further enhance our ability to execute.

So when we look at our new programs, programs that we're taking on, we approach each of them from the perspective of how do we manage the inherent risk that goes with a new development activity? First and foremost, that means being very clear about what all those risk really are, getting them out on the table as transparently as possible for all of us to focus on; and then secondly, in short [ph] that we have very strong risk management capabilities and practices baked in for everything that we take on. That's the discipline that we're driving in our execution.

In addition to our work and in terms of being able to execute more effectively, I would say that there are some very positive trends in our customer community that are helping in this regard. And one of the ones that I would point out is requirement stability. There's a lot of work that's been done over the last few years as a result of the efforts both at the OST level and in each of the services to enhance the acquisition team's ability to hold the requirement stable. Because we all know when it comes to these development programs, a major source of cost growth and schedule expansion historically has been requirements and stability. We simply as a nation can't afford that anymore. In order to execute well, we need to be able to keep the requirements stable, we need to of course drive the execution with great discipline from the companies and I have to give the services and OST a lot of credit for their attention to requirement stability. I think that's going to help a lot.

Now, there's a third component to this that is also really important and that is funding stability. Given the volatility that we've seen in the budgeting process over the last few years, this is an area where we need congress to help as well. We need that stability to be able to execute well. And when we get funding volatility on programs, that too can ripple the outcomes. So this is a matter of focus across the board and it requires all the players both the industry, the customer community and the congress to play their role in making this program successful and we're certainly determined to do our part. I've been encouraged by what I've seen both in the Pentagon and on The Hill with respect to the various defense committees recognizing the importance of all of these aspects to ensure we can execute well. But it's clearly right at the very top of the list of actions that we have within our company to drive good solid execution.

Operator

Your next question comes from the line of Howard Rubel from Jefferies.

Howard Rubel

Thank you.

Wes Bush

Hi, Howard.

Howard Rubel

Good. I'm going to ask the per se question, Wes and go back to backlog again. Sorry. But it's very unusual for an aerospace company not to report a backlog number and could you go through the logic as to why you won't provide interim numbers?

Ken Bedingfield

Howard, it's Ken here. At this point, I think the only comment I would make is to refer you to the 8-K and just to remind you that we do intend to provide annual backlog data at the entire company and at the sector levels in our 2016 annual report on form 10-K.

Operator

Your next question is from the line of Jason Gursky with Citi.

Jason Gursky

Hey, good morning guys, or good afternoon. One of the just quick clarification as well and a lot, on the clarification was mentioned the B-2 volumes look like they're a bit of lumpy this year. Can you give us a percent of what you expect them to be in 2016 relative to 2015 growth, but - and what the expectation was going forward. And then the bigger question is can you just talk about again for - it's all the talk within minuses from a revenue perspective in the aerospace segment that you might see over the next several years. We know about F-35, Long Range Strike we'll obviously see some growth, but are there any other pluses and minuses that we should all be cognizant of as we go out to profile in that business?

Ken Bedingfield

Jason, I would say that in terms of the B-2 volume question upfront, in terms of the lumpiness, I think that's just kind of a quarter-by-quarter thing. We do manage this business for the long term and no concerns about the B-2 or where it is. I would say overall, we expect B-2 volume to be relatively consistent in 2016 with where it was in 2015, somewhere in the $700 million range in terms of sales volume. In terms of the second part of the question on pluses and minuses in revenues, at aerospace, I would say again a fair number of moving parts. In terms of what's declining, probably the biggest piece of decline would be F-18. As that program ramps down, I think we're down to two per month sort of delivery schedule.

The other areas where we've seen a bit of decline in 2016 versus last year would be non-restricted space particularly AEHF, James Webb Space Telescope. In terms of adds to volume, we do expect that F35 will start to ramp here at some point and we're looking forward to when that occurs. The B-21 Long Range Strike Bomber is certainly something that we would see as ramping here. And then as I mentioned, the E2D program that is now into the multi-year production, we talked about Triton moving into LRIP and then I would say a number of restricted activities.

Operator

Your next question is from the line of Myles Walton with Deutsche Bank.

Myles Walton

Thanks. Good afternoon.

Ken Bedingfield

Hey, Miles.

Myles Walton

Wes, I was intrigued to see the company tie 30% of its annual incentive comp to pension adjusted net income growth for the first time this year. Your guidance would imply that it doesn't grow this year. So conceptually, this year - is one question, but then also, I guess you're now comfortable that the company and maybe the industry is centered in the back drop where it's not just a capital return, but there's actually underlying year-on-your compounding pension adjusted net income growth?

Wes Bush

I appreciate the question. It's kind of a reflection of the way we think about motivating our team. Clearly, if you look at the budgets that have been approved, '16, well, in terms of the investment accounts domestically here were up about 14% over 15% and '17, well, not quite as robust in terms of the present's budget is still up noticeably from where we have been in '15. Some question obviously about whether or not the congress can move beyond this two-year process of getting past the budget control act or the sequester and get us into a more stable long term factor. But if you do look at the present budget, it puts the investment accounts in a more robust position. I think you might argue whether or not it's robust enough, you know what's going on around the globe.

Given that, from a company perspective, we see our portfolio as being very well-positioned to take advantage of that healthier environment to better-support our customers with products and services they really need to address that tough threat environment that's out there. So we are looking at that aspect of our incentive plan even though it's stated on an annual basis as something that we are integrating more into the thinking in the company and the way that we're going to incentivize ourselves over time to make sure that we're translating this improved market opportunity space into actual increases in net income over a period of years.

So we tend to use our annual incentive plan as a way of ensuring alignment within the company around a way we're thinking about what we need to get done. You might recall a few years ago when we were taking on this initial thrust to change our outcomes on operating margin rates. We set that up incrementally over a course of several years, but it was a very strong communication within the company around this as our area of focus and this is the outcome we need to achieve and it was very effective. I expect that as we go forward and focus on this transition in the market environment, that we'll be able to generate a very positive outcome by ensuring that our team is focused on growing the bottom line, not just the top line. We need to make sure we'd bring the bottom line with us as we're growing over time.

I would not describe this as an either/or on capital deployment or net income growth. We do anticipate maintaining a very strong focus on returning cash to shareholders. How we do that over the course of time always varies a little bit. But I think you've heard both Ken and I say on our recent calls, share repurchase will continue to be a very important part of our strategy as well as having a competitive dividend from a payout ratio perspective.

We look at all of these elements of value creation as being very important, but I think you put your finger on it the right way in your question as we look at the changing market conditions, it will be important for us to incentivize our team to make sure that we are growing that bottom line as well as the top line.

Ken Bedingfield

Miles, if I can just add to that. I would say that I think Wes' point around the trajectory, it was important. What we've done here is really set a baseline in 2016 from where there's a trajectory for net income to grow from. So do not necessarily read this as 2016 net income as growing from '15, but we've set a base line that we're looking to grow from as we move forward.

Operator

Your next question is from David Strauss from UBS.

David Strauss

Good afternoon.

Wes Bush

Hi, David.

Ken Bedingfield

Hey, David.

David Strauss

Another question on F-35, can you just update us where you are in terms of locking in the various contracts? And then Ken, a question around revenue recognition. I think you're on units of [ph] now the updated revenue recognition standard, how could that impact you on F-35 and if so, when? Thanks.

Ken Bedingfield

All right. Great. Thanks, David, for the question. I would say a couple of things. I guess first to answer your question where we stand on contracts, just a reminder we do have four main contracts on F-35 with Lockheed-Martin. We've got the center fuselage, the radar, distributed aperture system and the CNI communications navigation identification suite and various aspects of those are in negotiation with Lockheed Martin, but I would say that what folks tend to think of as our main piece, that being the center fuselage - which is our single largest contract - we are negotiated through LRIP 8, continuing to work hard to get LRIPs 9 and 10 negotiated. Just working through the details with those with our customer.

In terms of the question on the REV/REX standard, very good question. We are on units of delivery for all four of our contracts on F-35 and we also have other units of delivery contracts - F-18 is one and some others within Mission Systems. We do expect that when we adapt the new REV/REX standard which should be in the first quarter of 2018, we would transition from units of delivery on each of those contracts to a cost-to-cost method of revenue recognition. That being said, we do not expect - and looking at the profile of those contracts that are on units of delivery and where they're going to be in their life cycle, we don't expect that the revenue recognized in that period should be significantly different from what would be recognized on the units of delivery basis.

The reason for that is that the cost to repute ultimately is pretty consistent with the unit flow that we see. So there could be some impact and there certainly will be some impact, but we have not at this point seen that as particularly significant for the adaption of that new standard in 2018.

Operator

Your next question is from the line of Sam Pearlstein with Wells Fargo Securities.

Sam Pearlstein

Good afternoon.

Wes Bush

Hey, Sam.

Sam Pearlstein

I guess more for Ken, but can you talk a little bit more about the capital spending? You had the $150 million or so building that you purchased this first quarter, it sounds like there's another one about to be teed up. Can you just help me understand how to think about what that means for the appreciation expense. Does it mean cap ex is going to be near the high-end versus the low-end this year in terms of just now that you've actually executed some of those plans?

Ken Bedingfield

All right. Let me see if I can address those in maybe three pieces. I guess the first part is capital spending in the first quarter. What I would say is yes, the building certainly was a significant piece of that. The other piece of it, I think is just continued projects that we've been working through in 2015 and you can think of those as generally being related to either some of the centers of excellence's work that we've been undertaking here in the last couple of years. As well as some that are programmatic in nature, in general supporting multiple programs whether it's programs that are in production and we're seeing some relatively solid production numbers in front of us where we determine we can invest. A great example of that would be the St. Augustine Aircraft Integration Center where we invested ahead of the E2D multi-year program because we saw that there was a relatively stable base of production for a relative long period of time.

I would say that some of it is the buildings that we've talked about and some of it is just kind of continued spend on the existing projects, much of which is either centers of excellence or program-related. But for the most part, if they're a program, they support multiple programs and not just a single. In terms of depreciation, what I would say is that we don't look at our indirect rates on a piece-by-piece or line-by-line basis. We've managed our indirect as a piece of our total cost and just because depreciation may be going up doesn't mean that we have an excuse to let our indirect rates increase.

So we'll manage and we'll continue to manage this as we have as component of total cost and to the extent depreciation is up, we'll have to find other areas where we'll realize cost savings. I think a great example of that is just if you look within the capital itself. The capital for the building we purchased in the first quarter and the capital for the building that we intend to purchase in the second quarter will result in depreciation charges that are significantly less than the rent expense on those buildings. So there will be savings in the indirect pools right there that would be a component of how we would offset those increases in depreciation charges going forward. But we certainly see that as something we'll be able to manage as we have in the past, aggressively looking at holding our indirect rates.

And then in terms of the range for cap ex, we certainly looked hard at that here as we were giving guidance for the first quarter. We believe it's appropriate to hold our range where it is, still a number of moving parts and a fair amount of time between now and the end of the year. But if we see some additional clarity on that between now and the other second quarter call, they'll certainly update that range as appropriate.

Operator

Your next question is from the line of Hunter Keay with Wolfe Research.

Hunter Keay

Hi, guys. Thanks. Good afternoon.

Ken Bedingfield

Hey, Hunter, how is it going?

Hunter Keay

Very good, thank you. A question on the IRAD. As we think about it, obviously it kicked up a little bit last year and I think I'll understand why that was the case and I was sort of thinking about that going forward as a percentage sales I mean, and if you want to answer the question on the context of sort of how DOD is maybe shifting all of the development expense over the industry. Are you seeing any particular areas where that emphasis of industry spending its own money is particularly emphasized like on radar programs or unmanned, or anything like that where you see a particular area of pressure to spend your own money to develop new systems? Thank you.

Wes Bush

Hunter, it's Wes. I think the thing to keep in mind with IRAD these are decisions that each company has to make on how it invest to position itself for the longer term. That really is the framework that we look at. When we think about IRAD, we drive the process internally to really test, “Are we making smart investments that really have the opportunity not just tomorrow?” Or sometimes you can just put in a couple of years, but over the long term, “Are these investments, they're really going to generate the opportunity to enhance our ability to support our customer and the result in profitable growth for the enterprise?”

There's a lot of judgment that goes into making those investments. We looked across the full array of customer needs and in response to the second part of your question, I would say all of our customers are looking at a threat environment that is going to require that they bring more innovation to the game to the products that they're out acquiring, they're going to need more innovation to ensure that we're going to be able to put forth a military capability that truly is differentiated technologically. So it isn't just one area. Probably all of the areas you mentioned plus many more are representative of our customer's needs today to really enhance their capability to address their very difficult and challenging missions particularly as we look around the globe and see many other countries investing on the technology front as well in that regard.

This is a core part of what we do, our fundamental business model. We invest, we bring brilliant scientists, and engineers, mathematicians together to figure out how to help our customers stay ahead. We don't want their effort to be a case where our service men and women have to go into a fair fight when it comes to the technology capabilities. We want to be with. These are our fundamental investment decisions that we make and given this growth in complexity that our customers are facing, I think it is incumbent on us collectively across our industry to be investing appropriately.

You saw us take our IRAD investments up over the last couple of years, up into the 3% range and I anticipate going forward we'll be at that higher level of investment because we'd see the business imperative both through our customer's eyes and through the eyes of generating returns on those investments. So long as we can make smart investments, apply those funds in the right direction and bring together the right human capital, we should be in a really good position to support our customer's needs.

That's the lens through which we see it. I know that there has been fair amount of public discourse about the need for both industry and quite frankly government to be spending more on investment, but I think it's just reflection of the reality of the thread environment. So we're stepping up, we certainly need government to step up in terms of this investment and fundamental R&D and product development. But I think this is something that's just a clear imperative and supports getting the right types of returns on those investments over time.

Operator

And your next question is from the line of Robert Spingarn form Credit Suisse.

Robert Spingarn

Good afternoon.

Wes Bush

Hey, Rob.

Ken Bedingfield

Hey, Rob.

Robert Spingarn

Hi, guys. Wes, I was going to ask you a program question and maybe it falls on a little bit from what you were just talking about, but you've always been viewed as a favorite for navy UCLASS strike platform which is now essentially been descoped down to a refueling system, CBARS. So I'm asking about how that changes Northrop's competitive discriminators? Does it alter where Northrop sees CBARS relative to other upcoming competitions, particularly given the major investments that you've made in the demonstrator prototypes?

Wes Bush

Rob, that's a good question and I think a really important one as we look at the underlying capabilities that will be required to support essentially any meaningful unmanned operation off the deck of an aircraft carrier. We're absolutely delighted with the ground work that's been laid by the X-47B program - taking off the deck of an aircraft carrier without a human in the loop is a neat trick onto itself, but landing on a deck of an aircraft carrier is a really neat trick and we're the only company that has done that, something of this capability.

So we see ourselves as well-positioned to support whatever the mission requirement that the navy derives or unmanned operations on and off the deck of aircraft carriers, and we're going to continue to work hard to support the navy on this. Clearly, there are some differences that go with the variability of whatever the mission might be. Strike as I think about it from a long term perspective is going to continue to be really, really important. The navy is concerned as well about surveillance and reconnaissance with an edition's carrier asset and they've chosen to focus this next round of activity on refueling, which is also a really important mission for the navy.

In all of those cases, they are mission-variants, but the underlying technology, the capability to design, and build, and reliably operate an autonomous - a truly autonomous system - in that type of environment, that's something that we've made a lot of progress on. X-47B was important for the navy in terms of demonstrating that this really could be done and I think CBARS and future variants of that type of unmanned capability are going to be really important opportunities for Northrop Grumman.

Ken Bedingfield

Hey, Robin, one more question.

Operator

And your final question comes from the line of Joe Zenardi [ph].

Unidentified Analyst

Thanks very much. Ken, I'm wondering if you could talk about just on the pension side? I think some of your peers are starting to see contributions ramp up over the next couple of years, so if you could just talk about what your required contributions look like going forward? I would imagine it's a little bit smoother than your peers. And then if you could just update us on FAS/CAS, maybe beyond 2016?

Ken Bedingfield

Yes. Thanks for the question, Joe. On pension, I would say that all things being equal in terms of where we are today versus where we were at the Q4 call in January where we provided some information on pension and without different assumptions, I don't see any changes from where we were then and at that point in time, I would say about call it on average, $100 million a year for '16, '17 and '18 in terms of required contributions primarily for our non-qualified plans and that was based on the discount rates at the end of the year and our expected rates of return. I would say that at this point in time, no major update from where we are there. We'll continue to evaluate that between now and at the end of the year and we'll tend to give some guidance around the third quarter call and an update to have our final assumptions at the end of the year.

But we're looking at again, with assumptions that just stand today, not a significant level of pension funding requirements which is certainly a good place to be.

Steve Movius

With that, I'll turn the call over to Wes for final comments.

Wes Bush

Well, thanks, Steve. Let me just wrap up by thanking our team again for a good start to 2016. It's clear to us that our customers really need performance and innovation to successfully address their demanding missions and our team is absolutely focused on supporting them.

So thanks, everyone, for joining us on our call today and thanks also for your continuing interest in our company.

Operator

Ladies and gentlemen, this concludes our today's conference call. Thank you for your participation.

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