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Northrop Grumman Corp. (NYSE:NOC)

Q4 FY07 Earnings Call

January 24, 2008. 09:00 AM ET

Executives

Gaston Kent - Corporate VP, IR

Ronald D. Sugar - Executive Chairman and CEO

Wesley G. Bush - President and COO

James F. Palmer - CFO

James R. O’Neill - Corporate VP and President, Information Technolog

Analysts

Robert Springer - Credit Suisse

Steve Binder - Bear Stearns

Cai Von Rumohr - SG Cowen Securities

David Strauss - UBS

Doug Hoenig - Sanford Bernstein

Joseph Nadol - JP Morgan

Heidi Wood - Morgan Stanley

Joseph Campbell - Lehman Brothers

Robert Stallard - Banc of America Securities

George Shapiro - Citigroup

Ronald Epstein - Merrill Lynch

Howard Rubel - Jefferies & Co.

Good day, ladies and gentlemen and welcome to Northrop Grumman Fourth Quarter and Year-End Results Conference Call. My name is Lauren and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session at the conclusion of this presentation. [Operator Instructions].

I would now like to turn the presentation over to your host for today’s call, Mr. Gaston Kent Vice President of Investor Relations. Sir, please proceed.

Gaston Kent - Corporate Vice President, Investor Relations

Thanks Lauren. And good morning ladies and gentlemen and welcome to Northrop Grumman’s fourth quarter 2007 conference call.

We provided supplemental information in the form of a PowerPoint presentation that you can access on our investor relations website at northropgrumman.com. The presentation will be available for a limited time and should be viewed in conjunction with today’s commentary.

Before we start please understand that as shown on slide two some of the matters discussed on this call constitutes forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect the Company’s views with respect to future events and prospective financial performance. Forward looking statements involve risks and uncertainties and the actual results the Company may differ materially from the results expressed or implied by the forward looking statements. More complete expression of these risks and uncertainties is contained in the Company’s SEC Filings including Forms 10-K and 10-Q.

During the call, we will discuss fourth quarter and full year results including the non-GAAP measures, segment operating margins and free cash flow, both of which are reconciled in our press release.

During today’s call, we will also discuss our outlook for 2008. Guidance will also include GAAP measures of sales, operating margin, earnings per share from continuing operation, cash from operations and non-GAAP measures, total segment operating margin and free cash flow. Just to advise you there is an updated release which will go out shortly correcting a transposition on schedule one of the release. In that schedule net income is shown as $1 billion or $1.709 billion, the correct number as is displayed actually in the release is $1.790 billion. It’s a simple transposition of those numbers. The 8-K filing which went to the SEC this morning is correct. I also want to draw your attention to schedule 6 of our earnings release which provides an adjustment of 2005 through 2007 results reflecting the transfer of a small organization from electronic systems to mission systems which became effective January 1. Schedule 6 is provided so you test your modules prior to the first quarter.

On the call today are our Chairman and CEO Ron Sugar, our President and CEO, Wes Bush and our Chief Financial Officer, Jim Palmer. Please go now to slide three and at this time I would now like to turn the call over to Ron.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Thank you Gaston. Hello everyone and thanks for joining to discuss our fourth quarter and full year results.

This is an outstanding finish to 2007 which was a record year by every key measure. Sales topped $32 billion, segment operating margin increased to 11% to $3.1 billion or 9.7% of sales. Operating margin grew 22% to more than $3 billion and EPS rose 16% to $5.16 per share. Cash from operations reached a record $2.9 billion with free cash flow exceeding $2 billion. We also increased our total backlog by $3 billion to an annual record of $64.1 billion. We continue to build on and strengthen the positive trends we have demonstrated over the last several years. To put this year’s results into perspective, since 2003 the full first full year following our last major acquisition, operating margin has more than doubled.

Operating margin rate has expanded 360 basis points from 5.8% to 9.4%. Earnings per share have increased by nearly 250% and cash from operations has more than doubled. We continued to deliver on our commitment to improve performance. The strength of our financial results allowed us to take several shareholder value enhancing actions during 2007. We increased the dividend by 23%, the fourth double digit increase in as many years and then an 85% increase since 2003. We repurchased $15.5 million shares of our common stock for $1.2 billion during the year. Our board recently authorized a new $2.5 billion share repurchase agreement, our largest till date, representing approximately 9% of our shares outstanding.

During the year, we also invested for the future with acquisitions of Essex Corporation, which has enhanced our capabilities and participation in the rapidly growing intelligence business, as well as acquisitions of Scaled Composites and Xinetics. Along with executing our balance cash deployment strategy, we improved our net debt to total capital ratio to 14% achieving the highest credit rating in our Company’s history.

One of the highlights during 2007 was new business capture. New awards totaled $34.8 billion. We are specially encouraged by several trends we saw in 2007. First our technology continues to be a competitive discriminator. We saw this in both our core markets, as well as adjacent markets and with new and non-traditional customers. We won competitions for Navy UAS, GPS operational control system, Ground/Air Task Order Radar called G/ATOR, and the CREW 3 Counter IED contract.

We were awarded a U.S. postal service contract to further automate mail handling, and we were also selected to outfit Marine Core’s CH-53E helicopters with our DIRCM missile defense system. DIRCM Technology also advanced in the commercial arena, where testing is now underway on Fed Ex aircraft. Secondly, during the year we were also awarded several contracts that mark the beginning of what promises to be a very long set of product runs for programs like the E-2D Advanced Hawkeye and the F-35 Joint Strike Fighter. These are both franchised programs that should provide profitable revenue for decades.

We were also awarded funding for the next lot of global Hawkeye, and large contracts for construction of the LHA 6 big deck and a 9 LPD assault ship. And early this year, we received the next increment of design and advanced construction funding for the first Gerald Ford class aircraft carrier CVN 78. We also saw an upturn in international business that was very encouraging. Examples here are the year Hawkeye award and the MESA radar for Korea.

Electronics, where most of our international business resides had record acquisitions in 2007, which approximately 25% is international and foreign military sales. In additional to traditional sales of electronics, we are also seeing substantial international opportunities for security and infrastructure protection, such as the United Kingdoms IDENT 1 program. Lastly, we’ve been very successful across the corporation in wining competitions in the intelligence and restricted arenas.

We continue to pursue $10’s of billion of competitive new business opportunities. We’ve discussed many of these outside opportunities with you in the past, such as the air force, aerial refueling tanker and the BAMS. But two important new opportunities I would like to mention today are the army’s aerial common sensor restart and the army marine core Joint Light Tactical Vehicle program, which we are doing in partnership with Oshkosh Truck.

On JLTV Northrop Grumman brings rich experience in the design, development and systems integration of conflex mission equipment on military platforms. Our partner Oshkosh Trucks brings unparallel ability in advanced, extreme duty vehicle systems. This combination will enable our team to deliver the best JLTV solutions to our nation's war fighters.

In summary, 2007 was a very good year for Northrop Grumman and for our shareholders. We captured business in new and adjacent markets, grew sales, improved performance, executed our balance cash deployment strategy, and announced several organizational realignments designed to position the Company for the future.

We also announced some changes in our senior management. Scott Seymour and Jerry Agee will be retiring from Northrop Grumman this year. Gary Ervin will Head Integrated Systems and Phil Teel will be taking the helm at Mission Systems. I want to thank both Scott and Jerry for their contributions to Northrop Grumman over the years. I also want to acknowledge the outstanding job Phil Teel did in leading ship systems, and his work on the recovery from Hurricane Katrina.

Ship building is moving in the right direction. Mike Petters will now take over as we combine new port news and ship systems into one business, which we will call ship building. Our rich bench of leadership talent will enable a seamless transition into this new structure across the Company. You will meet these terrific executives in their new roles at our upcoming investor conference on February 26th.

In looking at the year, we are pleased with our progress and we will continue to focus on improving opportunities going forward. We continue to be contained, keenly focused on growing our sales, expanding margins, increasing EPS and further improving cash performance. Looking ahead, we expect the positive trends of the just concluded year to continue in 2008. Our $64 billion backlog gives us a solid base for growth.

In 2008, we expect sales of approximately $33 billion, earnings per share of between $5.50 and $5.75 a share with cash from operations of $2.8 billion to $3.1 billion, and free cash flow of $1.9 billion to $2.3 billion. We had a terrific year in 2007 and 2008; it’s shaping up to be even better.

Now, I’d like to turn the call over to Wes Bush for additional discussion on Northrop Grumman’s operations. Wes?

Wesley G. Bush - President and Chief Operating Officer

Thanks Ron, hello everyone. My comments are outlined on slide four. From operational perspective 2007 was a year of solid improvement in program, performance and significant risk reduction. From a risk reduction perspective, several challenging programs have shown marked improvement and good progress towards completion. For example, we completed the restructure of the NPOESS contract and all pre-Katrina contracts and ships, which represent several billion dollars of our contract base.

We also settled two legal matters with Cogent and Goodrich. We successfully completed critical scheduled milestones on Box-60, with all hardware delivered and performing well in concrete. We are continuing to make good progress on the Falcon Edge Software, and we expect to retire that technical risk over the course of this year.

On Wedgetail, we are also making good progress. We are currently completing the development phase and transition into type acceptance testing later this quarter or early next quarter. The technical risk is retired with a combination of that testing, presently anticipated in the third quarter. And lastly on LHD8, we are continuing to make progress towards our scheduled year and delivery date.

I also want to provide a little more background on our recently announced organizational changes. Our primary goals and realignments are enhance support to our customers, better utilization of capabilities and resources, and of course operating improvements. Our customers including the Navy have expressed their strong support for these realignments. The combination of our Gulf Coast operations with new port news, will further enhance our world class ship building enterprise, and provide an integrated inter phase and four range of capabilities to our customers.

We will be able to more efficiently utilize our assets, deploy our ship builders and invest for the future to meet our customer’s needs. We do not anticipate any facility closures, or significant reductions in your employment levels, as a result of this realignment. In fact, we continue to be in a having mode in many of our ship building locations.

We do expect cost savings to result from the realignment overtime. We also announced our missiles business with approximately $900 million in revenue, will now report as a part of space technology. This comprises our ICBM and KEI programs, as well as our missile engineering center, and it is an excellent fit with our space technologies customers and its advanced technology profile.

This transfer will enhance our companies overall support to our air force and our missile defense customers, and it will optimize our capabilities and resources. Missile systems focus will be on our rapidly growing C4ISR business. Now, this change will be effective July 1st, so you won’t see it reflected in our financials until we report our third quarter results later in October.

We are also focused on improving our performance by strengthening program management over side and processes, increasing our discipline around bid and contract negotiations with strengthen threshold criteria, and of course driving cost competitiveness through process improvements. A good example of this is our recently established enterprise shared services organization, whose target is to deliver high quality enterprise wide services to our sectors at very competitive costs. These efforts will produce continuing improvements throughout the Company.

And with that, I’ll turn the call over to Jim for more detailed discussion of our financials.

James F. Palmer -Chief Financial Officer

Thanks Wes, and good afternoon, ladies and gentlemen. My comments begin on slide five and they will summarize fourth quarter and 2007 results, as well as 2008 guidance. The highlights for the quarter and for the year were sales growth, margin expansion both in dollars and in rate, earnings per share growth and record cash performance. As a result of our very strong performance, we exceeded our guidance for sales, EPS, cash from operations and free cash flow.

For 2007, we have improved by every measure. Sales were up 6%, segment operating margin is up 40 basis points to 9.7%, total operating margin rate is up a 120 basis points to 9.4%. Cash from operations reached a record $2.9 billion even after the $200 million of discretionary pre-funding of our pension plan in the fourth quarter. And free cash flow topped $2 billion, a record for the Company and an impressive of 116% conversion of net income.

Now moving to slide six, the businesses combined for a 10% increase and sales for the quarter, and a 6% increase for the year. All four businesses post a higher fourth quarter sales. Information and services rose 11%, ships increased 19% and electronics rose 8%. For the year, electronic and services is 11%, ships is up 9% and electronics is up 6%. These increases were more than offset by the – these increases more than offset the 3% year-over-year sales decline for aerospace.

The trends driving the fourth quarter and full year sales are consistent with the results for the first three quarters. For information and services, the drivers are, the large state and local programs we won in 2006, the Essex acquisition, new program wins, an additional revenue from existing intelligence programs, and then the Nevada test site programs.

We had a small increase in Aerospace this quarter, due to higher volumes for restricted and several space programs. This was more than offset by the expected downturn in integrated systems revenues, as large programs like the E-2D Advanced Hawkeye, the F-35 and the EA-18 Growler transition from development to production. Our electronics business continues to see a strong demand for electro optical and infrared countermeasure products, including the inaugural DIRCM contract with the marines.

Electronics is also seeing growth in communications in ISR, along with additional volume for restricted business. Higher sales for ships reflects the recovery from hurricane Katrina. Ramp up on LPD and LHA programs, the inclusion of revenue from AMSEC and higher volume for Coast Guard, aircraft carrier and submarine programs. Moving on to slide seven, segment operating margin rose 15% for the quarter and 11% for the year, and for both periods margin rate expanded by 40 basis points.

All four businesses post a double digit operating margin increases in the fourth quarter. And for the year, operating margin is up 37% for ships, 8% for our electronics, 75 for aerospace, and 3% for information services. Looking at the fourth quarter and full year trends, aerospace electronics and ships operating margin rates are generally in line with what we discussed, as our fourth quarter expectations in our last quarterly earnings call.

Aerospace operating margin is 100 basis points higher than the fourth quarter of 2006 at 9.7%. For the year, aerospace operating margin rate expanded 60 basis – 90 basis points to 10.4%. These increases are primarily driven by improved results and innovative systems. Electronics margin rate for the fourth quarter expanded 85 basis points to 12.1%, and for the year expanded 25 basis points. For the year, information services came at 8% in line with guidance, but the fourth quarter operating margin and rate are lower than I expected.

Information technology fourth quarter margin and margin rate reflect a higher percentage of lower margin state and local business. In addition, IT’s fourth quarter margins were also negatively effected by about a 120 basis points, due to final allocation of state income taxes among the sectors and year-end cost accruals. Without those items IT’s fourth quarter performance would have been in line with expectations.

For the Company, we expand our total operating margin rate by 80 basis points for the quarter and a 120 basis points for the year. Total operating margin increased $137 million, or 22% for the quarter, and $542 million also 22% for the, for the year. The improvements for the quarter and year-to-date review the better performance by all four businesses and lower net pension expense. Results for the year also include lower unallocated corporate expenses, primarily legal provisions. Our effective tax rate in the fourth quarter was 34.6% compared with 33.6% in last years fourth quarter. For the year, our effective tax rate is 32.9% versus 31.2% in 2006.

Slide eight provides a revised format for our reconciliation of net income to cash from operations, and free cash flow for the quarter and year-to-date. This new format summarizes non-cash items like the depreciation and amortization, stock based compensation and deferred taxes into a single line and highlight trade working capital. For the fourth quarter, including the $200 million discretionary pension pre-funding, cash from operations was $734 million. Capital spending was slightly higher than last year, bringing us the free cash flow of $432 million for the quarter.

For the year, major items driving the strong cash performance or higher net income and non-cash items reduced pension funding and improved trade working capital. We’ve been very focused on working capital improvements, which is reflected in our 2007 results. For the year, we’ve reduced trade working capital by a $142 million, despite a $1.9 billion increase in sales. Capital spending for the year totaled $685 million and outsourcing contract and software related costs are $137 million, bringing us the free cash flow of $2.1 billion and improvement of the $1 billion over 2006, and a 116% conversion in net income.

Now, lets move on to 2008 guidance. Actuals for 2007 and our guidance for 2008 are depicted on slide nine. But I want to provide some perspective on how I view the fundamental trends year-over-year. We expect 2008 sales of about $33 billion, a slightly more than a 3% growth. This estimate is for organic growth only, and we could see some upside to this number depending on timing and funding profiles for several new competitive programs, which were scheduled to be awarded this year.

Segment operating margin rate is expected to be in the mid to high 9% range compared with 9.7% in 2007. In comparing to 2007, keep in mind that our 2007 rate included a net positive impact of approximately 20 basis points for items such as the Katrina insurance recovery, AMSEC gain and completion of contract negotiations with customers, offset somewhat by a negative earnings adjustment on LHDA in the second quarter. So adjusting for the net impact of these special items 2008 does call for continued performance improvement and margin rate expansion for our operations.

Operating margin should improve to high 9% range, as result of lower pension expense and somewhat lower corporate unallocated expenses. For our EPS, we expect a range of $5.50 to $5.75. This 7% to 11% improvement over 2007, reported results will be driven by higher sales and higher operating margin. The EPS range assumes an effective tax rate of about 34% and a 2% reduction from 2007, weighted average share is outstanding through open market share repurchases.

Turning to cash for 2008, we expect cash from operations to be in the range of $2.8 billion, $3.1 billion, which reflects growth generally in line with that of net income. Free cash flow is projected to range between $1.9 billion to $2.3 billion, which should translate again to a net income conversion of a 100% or better. We will be providing more detail on trends we expect in our business segments at our investor conference on February 26th.

In summary, it was a very strong quarter and we crossed the finished line with record results and solid foundation going in to 2008. Gaston with that I’m ready to turn the call back over to you for Q&A.

Gaston Kent - Corporate Vice President, Investor Relations

Thanks Jim. Lauren, we are ready for questions now. And ladies and gentlemen, before we start, let me ask you would limit yourself to one question as you work or wait through the queue. Lauren?

Question and Answer

Operator

[Operator Instructions]. And your first question comes from the line of Robert Springer with Credit Suisse.

Robert Springer - Credit Suisse

Good afternoon everyone.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Hi, Robert.

Robert Springer - Credit Suisse

Yes, could you give us a little bit more color on your ’08 guidance behind the segment level?

James F. Palmer -Chief Financial Officer

Segment level guidance, is that what I have heard the question to be Robert?

Robert Springer - Credit Suisse

Yes.

James F. Palmer -Chief Financial Officer

And you are looking for sales their margins or?

Robert Springer - Credit Suisse

Well, I mean sales margins, just directional commentary to the extent that you can offer that, you know above and beyond what you’ve got here on slide nine?

James F. Palmer -Chief Financial Officer

Sure. Let me walk through the… both sales and margin rates as I see them. I do see sales growth essentially in information and services, aerospace and electronic systems. Ships revenues I think are the fairly constant year-over-year. In terms of margin rate, I expect information and services that kind of be in the low 9% range, aerospace ought to b e in the mid 9% or so, electronic 12% - 12% plus type range, and I think ships will be in the low 9% range.

Robert Springer - Credit Suisse

Okay, then on your free cash. The mid point on your guidance there implies a slight erosion in what was exceptional performance this year. I know you said a 100% or better, but you were at one point too. Could you talk about what needs to happen to maintain that 1.2%?

James F. Palmer -Chief Financial Officer

Essentially, being at the top end of the guidance range on free cash flow would, would get us that kind of conversion rates again.

Robert Springer - Credit Suisse

And is that all just in working capital or is there some movement in the CapEx plan?

James F. Palmer -Chief Financial Officer

No just you know it’s… Robert, I think the best way to describe it is -- we are at the very beginning of the year. I think there are opportunities, but you know and we -- as I have mentioned in the past, we are driving on working capital. We’ve made good progress, we are not finished. I think there are additional opportunities and it’s up to us to bring those home.

Robert Springer - Credit Suisse

Thank you very much.

James F. Palmer -Chief Financial Officer

Thank you Rob.

Operator

And your next question comes from the line of Steve Binder with Bear Stearns.

Steve Binder - Bear Stearns

Jim just a follow up. What’s your assumption for FCAS, you know in 2008 over ’07?

James F. Palmer -Chief Financial Officer

That’s about a $100 million improvement Steve in our net pension expense driven essentially by three items. Our discount rate is going to move from 6 to 6 in a quarter. We did have really good investment performance in the, in the plans this year. Above 8.5% long term rate return of assumption, where actual investment performance as a little bit above 11%, some very strong performance in a trophy market. And then thirdly the $200 million of pension pre-funding that we made in the fourth quarter also has a positive impact on that change in pension cost year-over-year.

Steve Binder - Bear Stearns

Okay. And then in the -- in space technology, you are the best sales increases that we’ve seen in the long, long time. In fact for many years, I’m not even sure. When was the last time that was repeated in the -- you noticed the restricted activity picking up in the quarter. Is that a -- is that a trend that we should see sustain in 2008. I’m not telling 14% growth, but is the growth in, in classified activity; can it continue in ’08, can we see strong growth out in space technology?

James F. Palmer -Chief Financial Officer

Steve, across the board we’ve seen increased restricted activities.

Steve Binder - Bear Stearns

All right. Thanks a lot.

Operator

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

Cai Von Rumohr - SG Cowen Securities

Yes, general corporate unallocated $224 million. How big was the check you wrote to Goodrich in the fourth quarter? And where you know, you said it only down slightly, but you had a couple of large abnormal negatives in ’07. I would think it would be down towards the 140 level, is that being too aggressive and if so why?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Well, you are partly right, Cai, we did write the check and settled with Goodrich late in the fourth quarter. Frankly from a quarterly impact it was insignificant, the bigger driver and corporate unallocated for the year is essentially the second quarter provision we made for a number of various legal items. There were some adjustments of legal items in the fourth quarter as well but it was by far not nearly the size of the second quarter adjustment in terms of corporate unallocated going forward I kind of look for about a $25 million or so decrease over the 2007 level.

Cai Von Rumohr - SG Cowen Securities

Okay. How come only so small given that these are all relatively large items you have?

Ronald D. Sugar - Executive Chairman, Chief Executive Officer

Just when I look at the trends, that’s kind of where I think we could be for the year.

Cai Von Rumohr - SG Cowen Securities

Okay. Great. Thanks so much.

Ronald D. Sugar - Executive Chairman, Chief Executive Officer

Okay.

Operator

And your next question comes from the line of David Strauss with UBS.

David Strauss - UBS

Good afternoon. Good morning. You talked about shifts, Jim flat in 2008. Could you just give a little more color around that. Obviously you had the strike impact in ’07, you are still operating… running a pretty low rate in the first and second quarters. I am just a little surprised you wouldn’t see a little bit of growth in that business in ’08?

James R. O’Neill - Corporate Vice President and President, Information Technology

I essentially see a little bit of growth, but I don’t know that it is not enough… it’s not the 4% number that I talked about for your information, for example, for your information and services. So there is a little bit of growth but it’s not a whole lot.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Yes, David, this is Ron. We have a variety of programs which are finishing up and we have a few others that are getting started and so I think its just basically a timing and a mix thing as we go through the cycle of destroyers and amphibs, large decks and what have you.

David Strauss - UBS

And to follow up Ron, can you maybe talk about longer term what do you see for the ship building business, you are partner on Virginia Class Submarine, laid out a pretty, pretty strong growth profile over the next couple of years personally driven by second sub of year. So just thinking about a little bit longer term what do you see for the business?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Well, we see a solid business going forward. We believe that the Navy will move to Virginia class per year in 2011 and probably that gives us some more ahead of time. As you know we are partners with Joe Dynamics, we are their sub-contractor and so while we set the work, our revenue is only that piece which we have. We also see the DDX program picking up but we will also have some tailing off of the DDG51 Destroyer line which has been a tremendous line for us in the next couple of years. We do see a steady production of aircraft carriers going forward and in fact the Navy has put a couple of carriers in their palm, I believe they are four year centers and this is of course the Gerald Ford class and in CVN-78 class. So I think overall I think we see a solid business, to echo Jim, I don’t think we see a dramatic up-spike in revenues but we do see a solid business and I think the story in ships is driving the performance levels both in terms of margins and cash a year over year better than a couple of years.

David Strauss - UBS

Thanks a lot.

Operator

And your next question comes from the line of Doug Hoenig with Sanford Bernstein.

Doug Hoenig - Sanford Bernstein

Good morning.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Good morning, Doug.

Doug Hoenig - Sanford Bernstein

I am interested in the real line in ship building and I know really for the last three years you have talked a lot about taking lessons learnt from Newport News and using that as in the Gulf Shipyards. What’s led you to the decision to do this re-alignment now and what levels do you expect to use to improve performance there?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Well, Doug, this is something we have considered since we made the acquisition of Newport News quite a number of years ago. The difficulty was that initially Newport News had some issues in terms of delivering carriers and what have you and then unfortunately as we got to the place where we are in good shape there we had Katrina hit us, which really was a devastating impact a couple of years ago and we felt that managerially we were much better off to focus on those two businesses with two very powerful executives, running those businesses, collaborating but running those businesses in parallel. We are now at a position where from a performance standpoint and recovery and regeneration standpoint in the Gulf, we can and we have announced the unification of businesses in terms of a single sector management team. We have in fact increasingly been working on moving best practices, capabilities both ways, by the way, not just from new partnerships but also the other way around. We think that putting a common management in place we will be able to accelerate that.

But more importantly, we will be to probably more agilely operate in terms of managing workflow peaks and valleys in each of those yards. It turns out as you look forward in ’08, ’09, ‘010, you do see some variations in manpower requirements in those yards and manpower’s actually crucial because they are the skilled people that we need to go to the ships. In some cases we have a demand for manpower in one of the yards and we have shortfall of work in the other. So we have the opportunity probably more agilely move the work back and forth as we need to. As Wes indicated we do plan to continue hiring, we have some strengths that are going forward in both areas and so we just think that we are going have a more efficient operational for it. I would also finally mention that it simplifies the interface with the Navy at the highest levels because now we have a single executive in charge of ship building business.

Doug Hoenig - Sanford Bernstein

And as part of this, one of the things that I understood of Katrina that you wanted to do in the Gulf was entry was quite a bit more automation and in fact news, news of the Katrina situation that we had a catalyst to start with a clean sheet of paper and do things somewhat differently. Assuming that’s the case, can you comment on how things have progressed in terms of automating things more and also will this re-alignment help in there?

Ronald D. Sugar - Executive Chairman, Chief Executive Officer

Yes, Doug. We have made substantial progress there. Let me ask Wes to give you a couple more pieces of color on that.

Wesley G. Bush - President and Chief Operating Officer

Yes. If you look at what we have done in the Gulf since Katrina, we did use this as an opportunity to retool our operations there. We defined the process for the workflow, we redefined the way in which the work actually gets done, introduced new technology such as wireless technology into the shipyard to help facilitate the flow of inventory and the application of labor in a more efficient way. So there are a lot of things that we have taken on that are going extremely well and I give the team in the Gulf, an enormous amount of credit for not only recovering from Katrina, but figuring out how to use that opportunity to step us ahead. So as Ron indicated we have an opportunity to bring a lot of best practices from Newport News to the Gulf and we have a lot of opportunity to bring not only longer term best practices but some more current, more recent ways of managing the workflow to Newport News.

We see the coming together of these two businesses as an important step in what we are working to achieve over the longer term of having a integrated shipbuilding enterprise that gives us that flexibility to deal with how we are getting the work done and how we are best satisfying the Navy’s demands as their demands change over time so this very best move is a step forward.

Doug Hoenig - Sanford Bernstein

Okay. Thank you.

Operator

Your next question comes from the line of Joe Nadol with JP Morgan.

Joseph Nadol - JP Morgan

Thanks. Good morning.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Good morning Joe.

Joseph Nadol - JP Morgan

I would like to ask you about state and local part of your IT business. I am wondering I guess first of all what’s the contract structure generally on those programs, is it fixed price or is it timed materials et cetera and is this intrinsically a lower margin business or are these big long term contracts where you are initially taking a more conservative booking rate and seeing how things go, maybe if you could help out a little bit with that?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Yes Joe. They are long term contracts up to 10 years in some cases, a mix of fixed price and time and material type activities. The activities over the last year have largely been more of a transition activity as opposed to a service, true service delivery if you will. So, we are seeing the very front end of these long contracts moving or transitioning the work from the prior provider to ourselves and as we go into ’08 we will be essentially moving out of that transition phase into a more service delivery type of phase.

Joseph Nadol - JP Morgan

Could you characterize after the fixed priced portions of or the fixed price contracts specifically. Is there sort of risk reduction as you go in and foresee what has been done and is that a risk and B, is that potential reward as you hit those milestones you are able to increase the accrual rates?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

All of that would be true and essentially with long term contracts and particularly IT long term contracts, there is always changes that occur whether it’s in the hardware or software applications. All of those are essential opportunities for further revenue growth and margin opportunity.

Joseph Nadol - JP Morgan

Just can you say when you hit some of the major milestones this year?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Essentially we transitioned San Diego at the end of the year and we will finish transitioning Vida kind of mid-year of ’08.

Joseph Nadol - JP Morgan

Okay. Thank you.

Operator

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

Heidi Wood - Morgan Stanley

Good morning. Ron, can you talk to us about, help us better understand DOD’s newly announced policy of requesting multiple prototypes on major acquisition programs? How does that affect Northrop’s business going forward?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Well, Heidi, I will give you… first of all I think its an interesting policy, its probably a very good policy, Secretary Young has obviously put that in place. The challenge is that you need a little upfront money to carry three guys instead of two, on the other hand these are very, very big weapons systems decisions, they have 30/40 year lifecycles. So, it is important to get them right in the beginning. We think this is great. Obviously it gives us an opportunity to participate and show what we can do and we would much rather win a program as a result of having the best offering as opposed to maybe writing the previous proposal. One example I can give you is the joint light tactical vehicle program which we did just recently announce our participation with Oshkosh, that’s a huge program, that could be a $50 billion program over the next several decades, it will replace all the Humvees in the inventory.

We think that the opportunity to demonstrate what we can do through a prototype period is an excellent idea and by the way, the contractors will learn from the government what they really want and the government will have a much better understanding of what it really needs to buy as it clarifies its sense of requirements, it has the benefit of competition. So I think that’s a good idea and there will be other examples of that going forward and obviously as the contractor will be, we will participate as the government wants us to.

Heidi Wood - Morgan Stanley

And do you see concern about this being funded on the contractor’s coin initially or does it look like they are prepared to fund those?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

I think in general, Heidi, these will be funded by the government. Of course there will be opportunities for the Company to invest some research money if they were appropriate but I don’t think we are back to the days, if you remember back in the old airplane competitions with the A12 and others, where companies were basically betting themselves, betting the farm on whether or not they would win the program. I don’t think we are going to see that. I think certainly the industry would find that fairly unappealing and those of us who are running these companies will obviously have to make our own decisions but I think we are looking at a case of generally funded prototypes.

Heidi Wood - Morgan Stanley

Hi and lastly, you have talked a lot about the efficiency that you are making in the Gulf and obviously it looks like they procurement bow wave and shipbuilding is finally on us. When, when you look going forward, when do you think you can get to 10% margins in ships?

Wesley G. Bush - President and Chief Operating Officer

I think over the next few years, is obviously we have to work our way through the inventory of ships that are already under contract, that we are working through what have euphemously called the pig and the snake in terms of the Katrina affected ships and we are working those through the system. So I would say within a few years we should be able to move in that direction and we are absolutely focused on moving the efficiency and the profitability of this business to a place where we think it should be or you think it should be and if you take a look at the progress we have made to date in the last few years despite the impacts of the Katrina, despite the impacts of the strike, I think you can see we have got a heck of a trend going.

Heidi Wood - Morgan Stanley

Great. Thanks very much.

Wesley G. Bush - President and Chief Operating Officer

Thanks Heidi.

Operator

And your next question comes from the line of Joe Campbell with Lehman Brothers.

Joseph Campbell - Lehman Brothers

Good morning. I would like to stay with ships if I can, I have sort of two things I don’t understand. Nick Chubraya was talking about his shipbuilding business sort of being catching, is about $500 million less than you in catching up to you this year and then growing 40% over the next three years that follow. So I am trying to understand whether there is a shift in the mix between the nation’s two shipbuilding programs where Judie’s winning and you guys are losing or whether you are just being more reticent about what you see going on. The second aspect of the shipbuilding thing that I don’t quite understand and maybe you can help me with this, just the sort of traditionally Newport News is an all cost plus known as a very expensive shipyard that builds very complicated nuclear power ships. And the Pascagoula Yards have been known as people that build fixed price ships and always have to compete and I just sort of, don’t understand how after all these years it will make sense to have the guy that normally is not that attentive to cost, run the shipyard that needs to be attentive to cost?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Well Joe, you have asked a number of questions and made a number of assertions whether you may needed to take it one at a time. First of all, I can’t really speak to Nick Chubraya’s forecast for ship building; you have to ask him about that. I am not aware of winning or losing, we are both building DDX’s together in partnership, we are both going to be building Virginia classes together in partnership. We have significant work coming in aircraft carriers. We have significant work in amphibious assault ships including the LPD line and the LHA6 newly awarded. We are not participating in LCS and we are not participating in bulk carriers such as TAKE’s, we are not participating in oil tankers or crew carriers and that sort of thing. So to that extent there might be some difference in the mix. But the things that I am aware of, we certainly know our plan going forward, it’s a matter of public record with the Navy. We are obviously partnered with the GD on subs we worked together on those. So I am not aware of GD winning and Northrop losing. In fact, quite frankly we find ourselves cooperating across the board on almost everything now as directed by the Navy. So that’s going very well. With respect to your…

Joseph Campbell - Lehman Brothers

So Ron, does that mean that we should expect very strong growth in ships. I mean Nick said this is the strongest part of the entire GD portfolio?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

I think that’s great and I am not predicting that at Northrop. What we are telling is that we see steady revenues in ships, based upon the mix we have.

Joseph Campbell - Lehman Brothers

Okay, great. Thanks.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Okay. Yeah, near term, yeah, long term. Yeah, long term. Who knows long term? With respect to your other comment, first of all, let me point out that a substantial portion of Newport News is work, its fixed price. In fact by dollar volume of the $3 billion or so they do there, overall majority of it is fixed price, in some form, fixed price incentive. As we move into the submarine work, its fixed price, the carrier production work is fixed price, they are extraordinarily attentive to cost at Newport News and Mike Petters is the executive who runs Newport News has been extraordinarily focused on efficiency and cost, because in fact it makes a significant difference to the profit of this Company of how he performs. The ability of both yards to work together and share best practices is very, very important. Yet there are somewhat different cost structures in both yards, for example the Newport News yard does need to maintain some cost structure additions to provide nuclear safety issues that we don’t deal within the Gulf, we streamlined the Gulf for that. And years and years ago, probably three years ago, the Gulf also did some nuclear work; it does not do that today. So we have different cost structures in different parts of the business. But fundamentally we are driven by costs and better cost performance results and profits. So I think what you are going to see continued attendance in that regard.

James F. Palmer - Chief Financial Officer

Hi. This is Jim. I would just point out or echo what Ron had said, in some ways cost type contracts, or as the customers are concerned about cost, as anyone else as. And with the margin rate emphasis that we have had, overrun in a contract to increase sales declines the margin rate which is not what we are after. So I can assure you that we are after delivering our cost commitments to our customers, to all of ourselves that we have used for our planning purpose. So, the emphasis is on equally on cost, whether it’s at Newport News or at Pascagoula.

Joseph Campbell - Lehman Brothers

Great. It just struck me given all the years of sort of two Navies, the nuke Navy and the rest of the Navy that you start announcing but there is kind of one customer?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Well, I think this is the future and I think what we are seeing is inter-relationships. If you think about it, when you have to fund an aircraft carrier, it takes a significant amount of total obligational authority away from other ships and when you don’t fund an aircraft carrier you could fund other ships. The natural effect of that rippling through the industrial base, is the movement of work. And we think that over time its better to be able to deal with this in an integrated way and we can basically share work and not have to rapidly hire and rapidly lay off the highly skilled workers. We found it over time, that industrial bases in both those shipyards is a much more efficient way to go. It’s win-win for the government, its win-win for us.

James F. Palmer - Chief Financial Officer

And in fact, I made a quick comment in my remarks earlier. Now the Navy has been very supportive of this and specifically for that reason that, you are right. Historically there has been more of a narrowly defined missions and budgets that plug with that and perhaps not as much cost over effect within the Navy itself. The Navy is looking to the future; they are taking actions to think about their portfolio in a more integrated, aggregated sense. And they see this step on our part as very aligned with where they need to go as well. So it works well together for us and for the customers.

Joseph Campbell - Lehman Brothers

Thanks. That’s very helpful. Appreciate it.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Thanks Joe.

Operator

And your next question comes from the line of Robert Stallard with Banc of America.

Robert Stallard - Banc of America Securities

Good afternoon.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Hi.

Robert Stallard - Banc of America Securities

Ron, just a structural question. You highlighted how much your operating margin has improved since 2003, do you think you are now as a Company reaching the point where the operating margin is like a slowdown in terms of its upward progress?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Yes, Robert. Clearly we have had a dramatic improvement in the last 4 years or 5 years. You are not going to see that going forward but we are going to see some improvement but at a slower rate.

Robert Stallard - Banc of America Securities

Okay. As a follow up, looking to the longer term as well, what’s your thoughts on the trajectory of the US defense budget, looking at both the core budget and the supplemental?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

I think every year this time, there is a lot of concern that the defense budget is either peaked or is going to be reduced substantially. We do not see that, Robert. We certainly see an ’08 budget which is substantially stronger than the ’07 budget. The Northrop programs and interests are very well provided for. Based upon our early understanding of the ’09 budget process and as you know that’s just still under way in the Pentagon and is not yet been presented to the Hill. Every indication we have is that there will be a continued growth of regional proportions in the basic budget. This is quite separate from the supplementals, but the very basic budget we expect is going to grow as well, in terms of procurement and RDT&E.

As far as the supplemental is concerned, that’s a different situation, that’s going to be debated by Congress here in the spring, there is going to be need for supplementals, obviously to handle the war, the operational issues. And also frankly some additional procurement re-plenishment. Where we go with those after the next administration comes in whether those are handled separately or whether they are part of the initial submittal, I do not know. One thing I will tell you though is that this corporation is reasonably resistant to a significant reduction in supplementals or a more rapid withdrawal from Iraq than maybe some other companies, but we are not participating, have not in the last several years, in much of the supplemental money. But the basic money in terms of the basic budget for procurement RDT&E, we see that continuing to be strong in ’09 and probably in ‘010.

Robert Stallard - Banc of America Securities

That’s right. Thanks Ron.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Thanks.

Operator

And your next question comes from the line of George Shapiro with Citigroup.

George Shapiro - Citigroup

Hi. Good morning.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Good morning, George.

George Shapiro - Citigroup

Just a couple of questions, the ship revenues were a lot higher in the quarter than what you have been forecasting for the year. Since that seems like a fairly predictable thing, so I was just wondering, kind of what happened in the quarter that you hadn’t captured it in your guidance before?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Ship’s revenue for the year essentially are right on our guidance at the very beginning of the year, George…

George Shapiro - Citigroup

You weren’t guiding for this much of an increase in Q4 relative to where we were in Q3. So I was just wondering?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

George, we have only given an annual guidance and we had arranged for ships and the actuals came right in the middle, of essentially that range.

George Shapiro - Citigroup

Okay. And then just in general, Jim, if you take a look at your guidance, you are getting 2% benefit in earnings from share reduction which is about $0.10, you are getting another $0.19 benefit from the $100 million increase in pension income. Granted that during the year you had some legal issues and you had some benefits. It wouldn’t seem just with those two items by itself, you get up to 540 or so. So it wouldn’t seem just off the top of my head that you are getting, projecting a big increase in the operating earnings out there and I am just wondering whether you are just being overly conservative or there is some major things that I am missing.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

George, as I think about the guidance going forward, essentially there are upsides or uppers from ’06, I am sorry, ’07, for pension, for additional volume. Tax rate is a negative. Earnings per share or weighted shares outstanding is a positive. And there are operational improvements that go into it as well. Those are the four items that essentially move from ’07 to ’08.

George Shapiro - Citigroup

Okay. Thank you.

Operator

And your next question comes from the line of Ron Epstein from Merrill Lynch.

Ronald Epstein - Merrill Lynch

Yes. Good afternoon guys. Ron, could you walk through in maybe a little bit more detail. You did some on your introductory remarks. Some of the upcoming programs that you are keeping your eye on?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Sure. Obviously the big news items are involving anchors, where we think that the current plan is to go to a defense acquisition board meeting. We have been told the 13th of February, which will be a review, it would be under secretary defense, and then following that of shortly there afterwards, pulled that there will be an announcement of a decision, winner take all. That same DAB date is the date for the BAMS program which is an unmanned reconnaissance program for the Navy. So that when we have in the middle of both those, we have our final proposals in on as to the competitors. I did mention the aerial comment sensor restart as you recall a couple of years ago, there was a competition. We are unsuccessful in that competition. However, within less than a year after the program was initiated, they were canceled, there was a reconsideration on how to proceed. Two things happened from that, one is a substantial amount of near term money came to us to upgrade the guard rail program, which we are doing common. And secondly, a decision to restart the Earl comment sensor competition, and we see that competition opening up this year, and probably get an RFP sometime later in the year and perhaps the down select in ’09. We have proposals in on PSAT, we have teamed with Lockheed, that’s a very, very large job for us.

We are providing the payload for the satellite next big portion of the job with our partner Lockheed. The JLTV, as we have said we have announced our anticipate… intention to participate there. And we were selected as one of two in a down select on the GPS ground station work. And we will be in a process over the next year or so of proceeding the bill prototypes in parallel with our competitor and then there will be a down select probably about a year from now on that one. So, and there are probably about another five or 6,000 other programs that were probably in the process of getting, preparing updates for, that will happen. So those are a few that I think kind of really catch the headlines.

Ronald Epstein - Merrill Lynch

Okay. Great. And then if I could just follow up, maybe just a smaller accounting question. On the quarter if you can take out some of the smaller M&A that you did, what was the organic growth for the Company topline?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

For the quarter? Ron, I guess it’s easier for me to answer it for the year I think, you take out the acquisitions and we are commenting it up 5% range organic growth.

Ronald Epstein - Merrill Lynch

Okay. Great. Thanks.

Operator

And your next question comes from the line of Howard Rubel with Jefferies.

Howard Rubel - Jefferies & Co.

Thank you very much. Two questions. One to go back to electronics. Very nice showing for the year and nice to see, it looks like you are getting some of the risk programs under your belt. Could you elaborate a little bit more on where you are in terms of the Mesa Radar and some of the other items?

Wesley G. Bush - President and Chief Operating Officer

Yes. Howard, its Wes. Let me take you through that a little bit. On both programs just to give you a headline summary, on both programs we are continuing to make good progress, and we are continuing to perform within our established EAC. So we are very, very pleased with how that’s going. You asked specifically about the Mesa programs. We are finishing off the developments test and evaluation phase. We have some software upgrades that are underway as well as I mentioned at the end of the third quarter, we are continuing to focus on getting the electro-magnetic interference testing done this quarter, the first quarter of this year. We do expect to get into the type exceptions testing later this quarter or early next quarter, in that kind of range or time span. And as we think about retiring the risk over this program, we are really looking to that type acceptance test set of activities to get that risk retired by the third quarter of this year. So good progress, we are pleased with what the teams are doing there. There is always challenges and risks on these leading edged programs, but if you look back to where we were, this time last year, we have made tremendous progress on both Block 60 and on Mesa.

Howard Rubel - Jefferies & Co.

And so I didn’t hear you talk about the $40 million exposure. Well I did find it in the queue, or do you feel more comfortable that going away?

Wesley G. Bush - President and Chief Operating Officer

There has really been no change with respect to our perspective on that so the exposure that we have in the queue continues to be our position on that.

Howard Rubel - Jefferies & Co.

And just a larger macro question for Ron. If you look at your outlook, it’s kind of 3% sort of growth number and while I recognize cash as more important than revenues. The budget overall is growing it at, we will call that high single digits, and so you are lagging a little bit. I know some of it is always mixed, but is there any incentive for you or for the broad sort of ask you to sort of step up the pace?

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Of course, we are trying to step up the pace, wherever it makes sense, but we also want to take on good contracts too. We are not just driving ourselves to topline. I am not sure about the high single digits. I mean that is a different budget than I am aware of. But certainly what we are involved in, we have given you our best guidance for it. Next year, we have not given you a longer range forecast. And remember the budget for next year with the government will be a planned set of commitments which will play out over the following years after that. We are certainly trying to drive the needle up as fast as we can. But we are much more concerned about cash earnings per share, and the quality of earnings. And then just pure topline we can obviously go get topline easily anytime to take on bad contracts. But I think that’s not something that we are about doing.

Howard Rubel - Jefferies & Co.

Thank you.

Ronald D. Sugar - Executive Chairman and Chief Executive Officer

Okay. Well we are at the end of the hour and I just want to thank everybody for your participation and we look forward to talking to you next quarter.

Operator

And thank you for your participation in today’s conference. This concludes the presentation, and you may disconnect.

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Source: Northrop Grumman Corp. Q4 2007 Earnings Call Transcript
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