洛克希德·馬丁 (LMT) 2016 Q2 法說會逐字稿

Good day and welcome everyone to the Lockheed Martin second-quarter 2016 earnings results conference call.

Today's call is being recorded.

At this time for opening remarks and introductions, I would like to turn the call over to Mr. Jerry Kircher, Vice President of Investor Relations.

Please go ahead, sir.

Thank you, Kat, and good morning.

I'd like to welcome everyone to our second-quarter 2016 earnings conference call.

Joining me today on the call are Marillyn Hewson, our Chairman, President and Chief Executive Officer and Bruce Tanner, our Executive Vice President and Chief Financial Officer.

Statements made in today's call that are not historical fact are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of Federal securities law.

Actual results may differ.

Please see today's press release and our SEC filings for a description of some of the factors that may cause actual results to vary materially from anticipated results.

We have posted charts on our website today that we plan to address during the call to supplement our comments.

Please access our website at www.lockheedmartin.com and click on the investor relations link to review and follow the charts.

With that, I'd like to turn the call over to Marillyn.

Thanks, Jerry.

Good morning, everyone and thank you for joining us on the call today.

We are pleased to have you with us as we review second-quarter results and our increased financial outlook for 2016.

As today's release details, we had a very strong quarter operationally and financially.

The Corporation continues to track towards another year of strong financial results while returning value to stockholders and delivering critical solutions to customers.

I want to highlight a few key items in the quarter, including the status of the strategic transaction in which our Information Systems and Global Solutions business will be separated from Lockheed Martin and combined with Leidos, and I will share some noteworthy operational achievements in our business areas.

Turning to the summary financials, our team continued to deliver broad-based results across the Corporation with second-quarter numbers exceeding all of our internal plans.

This strong year-to-date performance enabled us to increase full-year 2016 guidance for sales, segment operating profit, earnings per share and cash from operations.

As a reminder, the guidance continues to assume inclusion of full-year 2016 financial results from the IS&GS business.

If the divestiture of IS&GS is completed in the third quarter as currently anticipated, we will revise our 2016 financial outlook during our call with you in October.

Switching to IS&GS and the status of its combination with Leidos, significant progress towards transaction closure continues to be achieved.

We commenced our exchange offer on Monday of last week.

Also last week, the Competition and Markets Authority in the United Kingdom concluded its review, satisfying another condition to closing.

As we outlined in our press release last week, announcing the start of the exchange period, the offer provides Lockheed Martin stockholders the opportunity to exchange their shares of Lockheed Martin for shares of stock in a Lockheed Martin subsidiary, which then becomes shares of Leidos common stock upon completion of the transaction.

As you are aware, the combination of IS&GS with Leidos is structured as a tax-efficient Reverse Morris Trust transaction.

We will then retire the shares of Lockheed Martin stock exchanged, achieving a significant reduction in our outstanding share count.

The transaction remains subject to customary closing conditions, and closing is currently scheduled for August 16.

Switching to operational highlights, I will start with some key accomplishments and events on the F-35 Joint Strike Fighter program.

Overall, the program continues to achieve good progress across the multiple fronts of winding down development activities, ramping up production rate and sustainment activities and securing customer support and demand.

On the development program, key events this quarter included surpassing 60,000 flight hours of the F-35 fleet, demonstrating the increasing level of flight operations and maturity of the aircraft.

We are also achieving increased stability in the software on the aircraft and in the ground support equipment.

We continue to make strides in software development on the aircraft and in the autonomic logistics information system known as ALIS that is used to maintain the F-35 planes.

Evidence of this progress was demonstrated last month at Mountain Home Airbase in Idaho where F-35 fighters were deployed to a remote site to test aircraft performance and mission availability using the latest version of the maturing software.

During this deployment, the aircraft successfully cleared 88 of 88 sorties while also achieving 100% on-time performance of the sorties.

Additionally, the aircraft achieved zero avionic shutdowns on the ground or in flight due to any software stability issues.

Deployment met all of the customer's tactical objectives and proved that the aircraft can successfully operate at remote locations away from its home base.

These successful series of tests are key milestones in preparation of the F-35 CTOL fleet to achieve initial operational capability for the US Air Force later this year.

During the deployment tests at the Mountain Home base, the F-35 had the opportunity to engage with frontline legacy aircraft and performed exceptionally well in mock combat engagements.

The tremendous technological leap in capabilities that the F-35 provides are being demonstrated on a daily basis to a growing number of domestic and international customers as the aircraft is fielded at additional sites.

With the future price of an F-35 estimated to approach the price of a legacy fighter, the unmatched capability of fifth-generation stealth provided by the Joint Strike Fighter becomes even more compelling to customers as they recapitalize their fighter fleets.

Looking at the production activities on the program, progress continues to be made in ramping up the rate of production and reducing the cost of the aircraft.

On production, we are on track to increase our deliveries to 53 aircraft this year and have delivered approximately 180 aircraft since program inception.

In the area of cost reductions, we continue to make significant progress on our previously announced Blueprint for Affordability shared commitment between the government and industry.

To build upon that success, we announced two additional cost-reduction initiatives last week at Farnborough.

The first action is a two-year extension of our cost-savings investment that is designed to achieve lifecycle savings of more than $4 billion over the remaining production run of aircraft.

Additionally, we also announced an initiative over the next couple of years to reduce sustainment costs by 10%.

This action is expected to achieve $1 billion in savings for the five-year period and includes projects such as spare parts block-buys and establishing ALIS regional sustainment centers.

Turning to customer support and demand for the F-35, key milestones this past quarter on the domestic side include revalidation to Congress by the Department of Defense of the critical and unchanged procurement requirement to replace legacy aircraft with 2,443 JSF fighters for the US Air Force, Navy and Marines.

Internationally, support remains strong and growing with key events that included selection of the F-35 by the Danish Parliament as their next-generation fighter with the procurement of 27 aircraft; rollout of the first F-35A for Israel at our Fort Worth facility; and the arrival of the first two F-35A fighters into the Netherlands.

I was able to see firsthand the growing international interest and support of the F-35 earlier this month when I had the opportunity to attend both the Royal International Air Tattoo and Farnborough Air Shows in the United Kingdom.

Customers and attendees were able to see up close the revolutionary capabilities of both CTOL and STOVL F-35 aircraft at the airshows as they performed their aerial maneuvers.

This marked the debut of the F-35 at major international airshows demonstrating the increasing maturity and progress on the program.

We are honored to partner with international F-35 customers to strengthen the security relationships among our nation and allies as we collectively field this next-generation fighter for decades to come.

Turning to other areas in the Corporation, a noteworthy accomplishment was achieved on our Sikorsky CH-53K King Stallion helicopter program for the US Marine Corps.

The test helicopters on the development program continue to progress through a series of increasing payload lift weights to validate capabilities.

Recently, the aircraft successfully lifted a 27,000 pound external load, satisfying the contractual requirement for maximum lift weight.

With more than triple the payload of the predecessor CH53-E, the new helicopter can accommodate a range of missions.

The CH53-K can execute heavy lift missions more effectively and safely in day and night and all weather conditions using its modern glass cockpit.

To date, we have delivered three CH53-K helicopters on the development program that are enabling testing to move ahead and support the services goal to achieve initial operational capability planned in 2019.

Providing this enhanced capability is essential to our war fighters, and the Department of Defense program of record continues to project procurement of 200 CH53-K aircraft to replace aging legacy helicopters.

The CH53-K is also generating growing interest from multiple countries in addition to that in the United States and offers opportunities to expand production levels beyond the quantities required on the Marine Corps program.

I will conclude my remarks by offering my congratulations to our space systems team for their flawless support of NASA's interplanetary mission to insert the Juno spacecraft into orbit around Jupiter.

The Juno spacecraft was designed and constructed by our space personnel in Colorado and has been operating as a joint team with NASA.

After launch in August 2011, the spacecraft traveled 1.8 billion miles to Jupiter at speeds of up to 165,000 miles per hour for almost 5 years before successfully settling into orbit on July 4. Juno will spend nearly two years orbiting the planet while studying the structure, origin, atmosphere and magnetosphere of Jupiter for NASA.

The successful orbit insertion mission exemplifies the unmatched capability of our Corporation in making the impossible possible for our customers.

There were no second chances for this orbital insertion, and our spacecraft and teammates performed flawlessly in achieving mission success.

Before turning the call over to Bruce, I want to offer my appreciation and thanks to our IS&GS team.

Their dedication and continued focus on mission execution and our customers during this extended transitional phase has been superb.

With the upcoming closure of the transaction with Leidos, I am certain that the IS&GS efforts have made the business even stronger and helped position the new enterprise to generate value for shareholders and opportunities for employees as they move forward.

I will now turn the call over to Bruce to review our financial performance and updated guidance in more detail, and then we will open up the line for your questions.

Thanks, Marillyn.

Good morning, everyone.

As I highlight our key financial accomplishments, please follow along with the web charts that we included with our earnings release today.

If I start with chart 3 and an overview of our results for the quarter, sales for the quarter were $12.9 billion, well ahead of our expectations.

Segment operating profit was also higher than expected at $1.4 billion, resulting in earnings per share of $3.32 in the quarter, and we will discuss each of these metrics in the coming charts.

We generated $1.5 billion in cash from operations and returned $1 billion of cash to our stockholders in the quarter.

And as with last quarter, we are increasing our outlook for sales, operating profit, earnings per share and cash from operations.

All in all, we had a strong quarter and are well-positioned through the first half of the year to achieve our outlook.

On chart 4, we compared our sales and segment operating profit this quarter versus the second quarter of 2015.

Sales were higher by $1.3 billion, or 11% this year than last year, driven by the inclusion of Sikorsky and the results of MST for about $1.2 billion and nearly $250 million in growth at Aeronautics driven by $400 million higher F-35 volume, which more than offset two fewer C-5 deliveries in the quarter compared to last year.

Segment operating profit was $24 million higher than last year with the growth coming from the volume at Aeronautics and significantly higher profit in IS&GS and space systems.

These increases more than offset the effects of purchase accounting adjustments and transaction costs associated with the acquisition of Sikorsky, as well as the expected reduction of margin at Missiles and Fire Control.

On chart 5, we will discuss our earnings per share in the quarter.

Our EPS in the quarter was $3.32, which represents about a 13% increase over the EPS in the second quarter of last year.

This year benefited from strong operational performance, a higher FAS/CAS adjustment and a $0.04 benefit from the adoption of a new accounting standard, as discussed in our earnings release.

If you will turn to chart 6, we will review our cash from operations in the quarter.

Cash generated in the quarter was almost $1.5 billion, $200 million more than in the second quarter of last year.

This is particularly noteworthy given that we expected to recover a significant amount of cash associated with the completion of negotiations on F-35 LRIPs 9 and 10 by now.

Strong cash generation in each of the other four business areas beyond Aeronautics, including a large international receipt by Sikorsky, helped to offset the F-35 shortfall.

And while we expect to recover that shortfall soon, if additional funding is not received, the investment level will grow dramatically during the coming months.

Turning to chart 7, you can see the significant amount of cash returned to our stockholders in the quarter.

With just over $1 billion returned to stockholders evenly split between dividends and share repurchases, we returned over 80% of free cash flow in the quarter.

Chart 8 provides an update to our current outlook for the year.

As a result of the strong performance in the quarter and prospects for the remainder of the year, we are increasing our sales outlook by $400 million and our segment operating profit outlook by $125 million.

We will provide additional insight into these improvements in the next two charts.

We also increased our outlook for earnings per share by $0.65 and we will provide more detail into that increase in a few charts.

And we are increasing our cash from operations outlook by $100 million.

This obviously assumes that we receive additional F-35 funding, as we've already discussed.

And as a reminder, our guidance continues to assume the inclusion of full-year 2016 financial results from the IS&GS business.

Chart 9 provides the updated sales outlook by business area.

We increased our sales outlook by $400 million, $350 million in Aeronautics due primarily to higher-than-planned F-35 volume and $50 million in space systems reflecting the stronger start to the year than we anticipated.

On chart 10, we show the changes to our segment operating profit outlook by business area.

We increased our profit outlook by $125 million with $60 million of that increase coming from IS&GS as a result of its strong first-half performance.

Aeronautics increased by $40 million driven by the higher sales volume and space systems increased by $25 million reflecting it's better-than-planned performance to date.

Moving to chart 11, we have a reconciliation of our current earnings-per-share outlook compared with the first quarter.

The $125 million increase in segment operating profit increases our outlook by $0.25.

The newly adopted accounting standard for the treatment of equity-based compensation that we described in our earnings release increased 2016 EPS by $0.45.

This change in accounting is reflected as if it had been in place from the beginning of the year.

As a result, our year-to-date EPS includes a benefit of $0.37, $0.33 from the first quarter when the majority of our equity-based compensation vested.

The remaining two quarters of the year are anticipated to receive similar benefits of $0.04 per quarter totaling to the $0.45 increase for the year.

A number of minor other changes in the quarter amounted to a $0.05 reduction to EPS, and combined these changes increased our EPS outlook by $0.65 for the year.

On chart 12, we have a reminder of several key financial impacts that we expect when the IS&GS Reverse Morris Trust transaction closes.

We will receive a special cash payment of $1.8 billion.

At current trading prices, we would expect to reduce our common shares outstanding by about 10 million shares; though this is obviously subject to change as both Lockheed Martin and Leidos stock prices fluctuate during the exchange period.

And we would expect to have a significant book gain when the deal closes.

In addition to the deal closure in the third quarter, we expect to have a number of other significant events occur in the quarter as well.

Chart 13 highlights these upcoming financial events.

Obviously, the first significant event we are expecting is the IS&GS transaction closure.

The year-to-date results of IS&GS through closure will be moved to discontinued operations as will the book gain that we discussed on the prior chart.

We also expect to have a net pension gain upon closure associated with the departure of IS&GS employees.

This pension gain will be recorded in discontinued operations as well.

Corporate costs allocated to IS&GS up to the date of closure will be moved from IS&GS's results and reflected as other unallocated costs in continuing operations.

Importantly, there is no economic impact as a result of this cost reclassification and we will be filing pro forma financials.

Next, we expect to close on the F-35 LRIP 9 and 10 contracts and recover the significant operating cash tied to those negotiations.

We also expect to increase our ownership and obtain control of a joint venture within space systems to manage the Atomic Weapons Establishment in the UK.

A book gain will be recognized in our operating results upon closure of the transaction.

Going forward, we will fully consolidate AWE's financials and continue to report its operating results in our space systems segment.

Then we expect to finalize our Sikorsky purchase accounting adjustments next quarter.

And lastly, we will provide our trend information for 2017, including an updated discount rate projection and its impact on our expected FAS/CAS adjustment.

So you can see that we anticipate a number of moving pieces in the quarter, some of which are individually significant, but collectively will be quite significant.

We will provide updated guidance for all these events during our next earnings call in October.

Finally, on chart 14, we have our summary.

We had a strong quarter and that led to increases in our outlook.

The IS&GS exchange offer has begun, which places us on the path to close the transaction in the middle of August, and we remain focused on providing outstanding products and services to our customers and strong returns to our stockholders.

With that, we are ready for your questions.

Thank you.

In the interest of time, we are limiting you to one question.

Please return to the queue for any follow-up question.

(Operator Instructions).

Hunter Keay, Wolfe Research.

I realize this may be a little bit early to ask this question, but can you help us think about the work statement that you have with Turkey as it relates to the F-35 in the context of maybe some of the sustainment, and if you want to talk about any sort of longer-term implications from some of the recent activities there as it relates to the F-35 that would be helpful?

Thanks so much.

Sure, I will take that question and then, Bruce, if you have anything you want to add, I would be happy for you to do that.

If you look at Turkey, I know there's been a lot of churn in Turkey here recently, but it still remains a very valued NATO partner for us and NATO ally, and it's an essential security partner in that region for the United States and for our allies.

So we look forward to continuing our business relationship there and across a number of programs that we have.

We have not seen any indication that it will impact the F-35 or any of our other programs, and so we will continue to assess the situation and make sure that -- we will share with you if there's any impact on our business.

Their plan is to procure 100 F-35s, so they are a very important partner in that program.

Bruce, anything you want to add?

The only thing I would add, Hunter, is we've got a long history with Turkey.

We've worked with them since the pretty early days of the F-16 program.

We've actually built F-16s in Turkey.

As you know, and the heart of your question, we are also doing parts of the F-35 at TUSAS Aerospace Industries in Turkey.

That relationship has been successful.

As you said, it's probably early to call what the grand implications are, but they've been, as Marillyn said, a trusted partner with Lockheed Martin for quite some time and we hope that's the case in the future, obviously.

Pete Skibitski, Drexel Hamilton.

Nice quarter.

The F-35, the LRIP 9/10 contract, you talked about the investment level growing dramatically in the coming months, if it doesn't get signed, I think.

Can you size that for us and what's your sense of how close you are to the contract getting signed and are you definitely going to cash [upon] it if it doesn't close?

Yes, so let me give you just a little bit of color.

It's a good question, Pete.

So the current level, I think we disclosed in the earnings release, we've gotten nearly $1 billion or so that we are funding on the program, and that's a decision that we made to do that.

For whatever reason, the US government has not decided to put funds that are authorized and appropriated to fund Lockheed Martin and our subcontractor efforts on the contracts.

So we made the decision at the time that we were going to not allow a stop on the program and cause a disruption on the program, particularly in our supply base since that's where most of the work is being done at this time on the F-35 LRIP 9 and 10 contracts.

So we've been funding that for a while.

We continue to ask for funding recovery from the US government.

To this point, they have not funded us.

At some point in the future, because of the growth that we see over the next few months -- and you should think of this literally growing, Pete, in the $400 million to $500 million per month sorts of levels.

We will not be able to sustain that, so that if we don't either get funding through a funding mechanism such as a UCA funding item or we definitize the contracts, we will not be able to continue and have that level of cash outflow as a corporation.

We simply don't have that capacity.

The Pentagon clearly knows that situation, and I'm optimistic that we are going to get cash soon.

Rich Safran, Buckingham Research.

I know I usually ask a question about programs, but today I have one on pension income and cash-funding requirements.

Now, if you would, relative to where rates were in 2015, I wanted to know if you could maybe discuss what you expect for 2017 for FAS/CAS income.

Also, can you give us maybe your best estimate regarding whether or not you are going to have a cash contribution to pension next year.

If so, how much?

Maybe you could give us a range on that?

Anything you could give would be helpful.

I will take out one, Rich.

Thanks for the question.

So we are probably a little early to be talking about 2017 -- at least it feels a little early to be talking about 2017, but I think it's a fair question given all the changes that have happened in the interest rate environment here recently, particularly after the BREXIT situation.

I think what are 10-year treasuries going for, 1.4% or thereabouts, so dramatic reduction from the start of the year to now.

I think we ended the year at a discount rate of about 4.375%.

If we were to strike a line in the sand right now, it's probably 100 basis points lower than that.

You tell me whether you think it's going to increase between now and the end of the year or not, but if it did not, every 25 basis points change in the discount rate from where we ended last year is worth about $125 million delta to FAS expense.

So that's a pretty significant reduction in the FAS next year.

Our asset returns, you didn't ask about those, but that's the other component in the mix.

The asset returns are actually tracking pretty nicely towards an 8% return.

We've had a nice lift in the equity markets, particularly domestically here recently, that have helped with that situation.

So if I were to predict, again striking the line in the sand, our current FAS/CAS in 2016 is roughly $975 million or so of income.

Looking forward and just carrying those impacts into 2017 that I just described, 2017 would probably be $350 million, maybe $400 million lower than 2016, still income from FAS/CAS, if you will, but not as much income as what we've been expecting and talking about previously.

As to your cash-funding question, there is no impact next year at all associated with the discount rate change.

ERISA, which requires the funding levels for our pension trust, is far more sensitive to asset returns than the discount rate changes.

FAS is sort of an instantaneous discount rate impact whereas ERISA is spread over time.

So we wouldn't expect any change whatsoever in the funding requirements in 2017, still zero.

Joe DeNardi, Stifel.

Bruce, I think you talked last quarter about 2018 pension contributions, and apologies for asking a question that's so far out in the future, but you said that you think you can fill most or if not all of that gap.

I'm wondering if you could provide a little bit more detail about, of the $1.5 billion in contribution, what's the cash tax benefit and then what are some of the other areas you see as helping you guys fill that gap?

Thanks, Joe.

So I actually plan to give a little more insight into the 2018 numbers probably in the October call, but let me take a shot at it now just because you asked the question.

So we have said -- 2017 we talked about being the last of the three year what we call pension funding holiday that we announced I guess at the beginning of 2015.

As Rich asked in his question about cash funding, we don't see that changing in 2017.

In previous quarters, I did talk about 2018 having a required pension contribution, and obviously that's still the case.

However, what I was trying to convey, and the number you threw out, about $1.5 billion, it's floating around there.

It maybe a little bit higher now.

But what I was trying to convey on previous calls and what I will try to convey on this call is that you shouldn't think of the current level of operating cash dropping by the full amount of pension funding in 2018 and that's really for a couple of reasons.

One is we expect to get much stronger cash flows from Sikorsky in 2018 versus what we are seeing today.

We expect to have higher cash flow from F-35 than we are seeing today.

And then, lastly, as you described in your question, we also will get a tax benefit associated with the pension and cash contribution in 2018.

So think of that as 65% simplistically of the cash contribution is what will be a hit to operating cash in that year, if you will.

Sam Pearlstein, Wells Fargo.

I was wondering if you could talk a little bit more philosophically just about capital allocation and share buyback.

And I know you have a target of less than 300 million shares outstanding.

But just trying to think about where the stock's multiple is now and just trying to think about how you factor that into what you do with your capital and whether that makes other alternatives more attractive than repurchasing shares.

Let me take a shot at that, Sam.

So it's a great question.

As far as capital allocation plans, we still feel strongly about the dividend, capital allocation that we provided to shareholders.

If you just look at the composition of our shareholder base, it's probably -- I don't remember -- 30%, 35% -- I'm looking at Jerry as I say this -- 30%, 35% of our investor base is income-based, so that's a pretty significant element of our ownership that is driven in fact by the dividend yield.

So that's an important aspect of capital allocation going forward.

I always say that I think the best indication of what we will do there is the track record we've had in the last few years, or even a decade or more, relative to dividend contributions.

We still have some options that have yet to be exercised.

The option exercises actually have slowed down quite a bit.

You might remember, Sam, you've been following us long enough.

Years ago, we had a lot of dilution as a result of options being exercised.

That level has come down quite a bit, but there's still a backlog of options out there that as those do get exercised, we will clearly do share repurchases to offset that dilution.

We will do share repurchases to offset dilution from the equity compensation as well.

And then from that point, Sam, as usual, this may or may not be the most satisfying answer you'll get, but as usual it sort of depends on what's available in terms of capital allocation at that time, including other opportunities to invest in programs, acquisitions, that sort of thing.

The one thing that probably doesn't make a whole lot of sense, at least at this point, is to let it just sit idly on the balance sheet making as little interest as, in fact, it does.

I will remind you -- and I know you know this, Sam -- but the RMT transaction will reduce sharecount pretty significantly on its own, probably somewhere between 9 million and 10 million shares at current trading.

And on top of that, we get the $1.8 billion special payment, as I talked about.

And lacking a more pressing or -- what's the word I'm looking for --?

Opportunistic.

That's a good word, Marillyn -- opportunistic use of that $1.8 billion, I would think a good chunk of that would probably go towards share repurchases.

Doug Harned, Bernstein.

I'm interested -- Bruce, you clearly had a very good quarter and you said that it was a surprise to you all I think that the sales and your profitability were up as high as they were.

Could you talk a little bit about that because if I look forward for the rest of the year, is the surprise you had something that suggests your ongoing performance may actually be better perhaps than you had been expecting, and the guidance change doesn't really suggest that?

So I'm just wondering what you took away from the quarter and what that means for the longer term?

Yes, it's a good question, Doug.

I'm very happy with the first half of the year, and I don't know -- did I use the word surprise?

I will say we were pleasantly -- higher than expected or higher than planned for a couple of items, including for instance the ULA equity earnings that we got in the quarter.

Some of this was fortuitous in terms of the mix of launch vehicles, also the pricing of the launch vehicles that we had in the quarter for ULA.

So, for instance, we had a Delta-heavy launch, which is the most expensive launch vehicle that ULA produces, went off in the second quarter.

That helped the earnings in the second quarter.

Things like that, again, for the first half of the year, all helped us.

You are quizzing a little bit about, wow, that didn't necessarily translate into the full year.

I will say we kind of gave the first-half performance in the outlook for the year and we definitely have the opportunities that I think you are alluding to, Doug, in the second half of the year, but we have to make those happen.

And sometimes things don't work out as planned, and that's probably the reason that we provided the guidance that we did.

But nothing taking away from -- we feel very, very good and pleased with the first-half performance of the year.

Myles Walton, Deutsche Bank.

Thanks.

Maybe just to follow up on that with a little more specificity on Aeronautics.

I'm curious why the second-half EBIT implied in the guidance is flat to maybe even down a touch versus the first half on higher volume, and then I think you were also recovering the restructuring expenses you had in the first quarter.

So is there a mix?

Is there something else maybe, Bruce, that you can help us explain why Aeronautics isn't going to outperform that guidance?

Yes.

Good question, Myles.

So look, I -- kind of in the answer to the question from Doug -- I'd like to think we have, as I've said in previous calls, the same sort of opportunities to have a good second half as we had in the first half.

The one probably most notable change from first half to second half is the fact that we had some F-35 production stepups in the first half of the year, particularly on the winding down of LRIP 7 aircraft deliveries and a little bit of stepup on LRIP 8 as we go into a higher ramp rate there.

We don't currently have plans for F-35 production stepups for the second half of the year and so that's one of the things that will cause the second half of the year to look a little lighter probably than the first half of the year.

And then secondly, the volume level of F-35, as I alluded to in the reason for the change in our guidance for the year, is really expected to be higher in the second half, and that has that dilutive effect on the overall margins of Aeronautics that I've talked about in the past.

So those two reasons probably both netted to F-35, one was the stepups that occurred in the first half and secondly is just the volume in the second half.

Howard Rubel, Jefferies.

Marillyn, you put one of your top managers at Sikorsky to run the business.

Could you give us a six-month read on where you are and how it's going?

It looks to me like it's a little more expensive out of the box than one would have first thought.

Well, you are right about putting one of our top folks there.

We have Dan Schultz who has run large businesses for us in the past and also is a helicopter pilot out of the Marine Corps, so he knows the business extremely well and is doing a great job there.

I will tell you, I'm really excited about a couple of things, Howard, that we've seen in the past six months.

First off, we are tracking to what we had planned.

While from your perspective it may be different, but frankly we are right on plan with what we track.

But what I'm excited about is some of the revenue synergies that we see just by getting the integration process well underway and getting our teams together.

For example, I was at the Farnborough Airshow, as I mentioned earlier, and we showcased an armed Blackhawk helicopter that's taking weapons systems and sensors and things from our missiles and fire control business, combining it with the platform that's in mission systems and training Sikorsky business and showcasing that at our chalet there in Farnborough, and we had a tremendous amount of interest in it.

A lot of customers are now following up with us on interest there.

So that's just one example.

We've got many other examples where our teams are getting together and we see a chance to do just what we thought when we purchased Sikorsky, and that is to not only get the cost synergies of bringing that element into our business, but also -- but more importantly to get the revenue synergies and get the growth moving forward on it.

So we are on track.

We've talked before in this call about our commercial (technical difficulty) Sikorsky and the oil and gas price pressures on that business, but we've been very frank about where we stand on that, and based on what our outlook was and what we set for the year, we are right on track with that as well.

Howard, just to add maybe a little bit to what Marillyn said relative to the armed Blackhawk only because I think it's an interesting little tidbit there.

So you should think of this as essentially taking a utility helicopter platform and essentially transitioning it into an attack platform.

The interesting thing from the way the design was conceived and the way it will be sold internationally, especially, is you can remove that capability.

So within a day's time or so, the weapons packages and so forth that are put on to make this an armed platform can be removed from the helicopter, and the next day it can go out and perform a mission of a utility helicopter.

That's some flexibility that doesn't exist right now in the marketplace and that's something that we think is very interesting that frankly would not have happened, but for the synergy between our missiles and fire control organization, our MST organization and obviously Sikorsky now.

(Operator Instructions).

Ron Epstein, Bank of America Merrill Lynch.

Maybe a quick update post-Farnborough on what's going on with the trainer program and the timeline for that and how you expect it to go.

So on the TX program is what you are referring to I'm presuming for the Air Force?

I guess where that stands right now is we are standing by with what we consider to be a very good offering.

It's an excellent solution.

It's low risk.

It's the T-50A in our joint venture with Korean Aerospace.

It's flying right now.

We've already had our first flight of our offering, so we've taken that T-50 with KAI and converted it into the T-50A to meet the requirements that the Air Force has outlined and we are excited about the fact that we've flown it.

We are demonstrating it and we think we have an excellent offering.

Now the RFP appears to be slipping out.

It's slipping out into the December timeframe, so I think what I understand is that the Air Force wants to revisit what they've outlined as the requirements for that capability and they will slip the RFP out some and we stand ready to support that.

But, in the meantime, we are continuing to roll out our capabilities and showcase that capability.

It's a big program.

It's about 350 aircraft, so it's an opportunity for us.

In our case, there is some discussion around whether or not the Air Force wants to pursue a clean sheet design or an existing design.

We believe that with the tremendous gap on the training capabilities, the T-38 is -- I think it's close to 50 years old or something like that.

They need to replace that aircraft.

And the fact that we have a low-risk aircraft that's already flying that can meet today's requirements, we think we are offering something that would allow the US Air Force to move forward on the program and meet that capability.

There are other offerings out there as well that are not clean sheet, and so we like to compete and we think we have a tremendous offering.

George Shapiro, Shapiro Research.

Yes, Bruce, a couple of quick things.

Previously you had said that, with the Leidos transaction, that you would buy sufficient stock to offset the dilution.

Given where the stocks are now, you'd probably have to use all of the $1.8 billion and maybe even a touch more to offset the dilution.

So is that still the intent?

And then second, you took about a $30 million charge it looks like on the international contract that you alluded to in the Q1 document and I was just wondering if you think that's the end of it.

Thanks.

Thank you, George.

So relative to the share count reduction and whether or not that's enough to offset the dilution effects of losing the IS&GS earnings or not, you are right.

At the call when we announced the deal back in January, we said that the share buyback was essentially going to be enough to make that neutral between the two years.

Since that time, our stock has increased.

If I look at it today, it's up almost 25% over what the number was in January.

I think we were trading at around $210 a share the day we announced the deal.

So a pretty significant increase on our side, which makes it obviously more expensive to buy back the same number of shares as we had expected in the January call.

On the other hand, the Leidos stock price has dropped a little bit since that time, so both of those are working against us from a share perspective that will be taken out as a result of the RMT transaction.

So as we sit today, George, even with the $1.8 billion, it's probably difficult to get exactly to neutral, but it gets a lot closer there.

We still think the economics of this deal relative to all options that we looked at -- an outright sale, a pure spin -- this is still the best situation for Lockheed Martin and its shareholders and we don't have regret on that; notwithstanding the fact that, to your point, we actually may see a little bit of EPS dilution as a result of the stock price moving.

I think that's a little bit of a high-class problem that we are experiencing right now, but nonetheless that is where we are.

As to the charge we took, we did take an additional charge -- $30 million, you are right.

This is the command and control business that we are looking.

So think of this as a system that controls all sorts of air missile defense capabilities around an entire country, including identifying friend or foes so that you don't have the wrong issues with that air missile defense capability.

So linking into a lot of different systems.

We think we have prospects, once this system is developed in other places internationally, but we've had some growing pains obviously with this, and I think as we've gone through the development and early stages of this program, the customer has changed some of what their expectations are.

So we are in discussions with the customer right now about closure of this contract.

We think where it sits right now it's pretty well-positioned in terms of the charges we've taken.

There's some upside potential to that depending on where the customer wants to head.

There could be some downside, so we are in the middle of that right now, George.

And obviously we will keep you apprised as we go through future quarters and let you know how we are performing on that contract.

Rob Spingarn, Credit Suisse.

Just going back to the F-35, Bruce, you've talked about double-digit margins I think in 2019 and in context with the two new initiatives that Marillyn spoke about that were announced last week, I guess that's around $430 million in new costs, and clearly both you and the government are trying to get the best deal done here on 9 and 10.

Is that still the trajectory, and how have margins been tracking lately?

So, Rob, that is still the objective, and just a slight correction maybe on what you said.

The two initiatives, the second part of the Blueprint for Affordability and the sustainment activity is more like about $420 million.

I will remind you this is an investment (multiple speakers).

I think your question was that's shared.

And it is in fact shared between ourselves, Northrop Grumman and BAE, just as the first Blueprint for Affordability initiative was.

I started to say these are investments and you expect to get returns on your investments.

We are getting a return on the Blueprint for Affordability I. We would expect to get returns on Blueprint for Affordability II, as well as the sustainment investment that we are making.

But notwithstanding that, I still think we are on a trajectory on the F-35 program.

I think I've said more than having the specific year, relating more to when we would get full-rate production that we hope to get to double-digit margins by that time.

I've always said, at similar points in time of the programs lifecycle, it ought to look like an F-16 program or an F-22 or a C-130.

There's nothing structurally that would prevent us from getting to those levels.

And right now, we are tracking towards that trajectory.

We've not come off that at all.

David Strauss, UBS.

Bruce, hate to do it, but going back on pension, I think previously you had said FAS/CAS for 2017, all things staying the same, discount rate hitting your assumed rate of return would be about a $450 million positive relative to 2016.

So wanted to clarify your answer on the prior pension question where you talked about $350 million.

Are you talking about $350 million worth off of the projected 2017 level or off of the actual 2016 level?

And then the other thing, the $1.8 billion that you are getting in conjunction with the closing on IS&GS, would you potentially look at that for an early pension contribution to potentially offset some of the downside?

Thanks.

Thanks, David.

And I probably wasn't at my clearest when I made that reference in the first quarter.

I think I heard feedback as we went around at investor conferences and so forth that I think I stumbled with my answer there quite honestly.

So I tried to be clearer this time.

Obviously, I'm still not being clear, but let me try to be as crystal clear as I can on this thing.

So FAS/CAS in 2016, the benefit is about $975 million or so.

What I said is I would expect to be between -- if we struck the line in the sand right now -- probably $350 million to $400 million lower than the 2016 FAS/CAS benefit in 2017.

To do the math, that translates into $625 million, $600 million-ish income number, down considerably from what we were talking about in the first quarter of last year.

Almost all of that because of the discount rate change and 100 basis points, as I talked about.

Importantly, back to Rich's question, it's a non-cash item.

Will not affect our 2017 contributions at all.

And that relates to your question relative to the $1.8 billion and would we use that to pre-fund a pension plan.

The answer is we don't have that expectation sitting here today, and I don't think that's what we will do with the money.

As I said earlier to another question, I think the more likely outcome is probably share repurchases at this point in time, and we will fund the 2018 requirement in 2018.

We've already got, quite honestly, a fairly sizable prepayment credit balance in terms of how much we have contributed to ERISA versus what we've collected from our government contracts and we don't see the point at this time of increasing that level.

Cai von Rumohr, Cowen and Company.

So in the quarter, you had a reasonable book to bill of 0.85 at IS&G and yet my understanding is that number excluded the FAA contract you got recently and the protested ISR award you had in the second quarter.

And yet you also mentioned the Australian contract had another scheduled delay.

Can you update us, as you look at next year, what the IS&GS -- any color on where the IS&GS numbers might be?

So, Cai, I think that's probably crossing into an area where we are better suited to point you to the prospectus that we've got for the RMT transaction rather than me comment on what IS&GS sales would look like under Lockheed Martin in 2017 when that's not our expectation.

Carter Copeland, Barclays.

Just a question on the F-35, just to clarify and a second part.

The sustainment initiative on reducing those costs, you said 10% reduction there or $1 billion in five years implies clearly a very large sustainment amount, a $10 billion amount.

That seemed kind of large.

I just wondered if you could clarify if that was correct.

And then, secondly, with respect to the contract action, if you end up getting a UCA on this in the coming quarter or two quarters, Bruce, is there a particular cost or margin impact to one contract outcome versus another that you are considering in your guidance or in the plan?

How should we think about that in terms of how that gets finalized with the customer?

Thanks.

Thanks for the question, Carter.

Let me just take the first one on the Blueprint for Affordability for sustainment.

What we announced was an investment of up to $250 million over the next couple of years, much like we did on Blueprint for Affordability for production, this time for sustainment along with BAE and Northrop Grumman.

And we are targeting over that five-year period that we would reduce sustainment costs by 10%, so that's where the $1 billion savings for that five-year period would come from.

We've got a lot of projects that we've outlined and so it will be jointly with the US government.

They will approve those projects.

We will implement them, and then as Bruce said earlier, we will get a return on our investment.

I think that answers that question unless there's something more there, Bruce, that you want to add.

Nothing to that.

I will try to address the F-35 LRIP 9 and 10.

So maybe a little bit more than you want, Carter, but there's two ways that we could get cash recovery on this program.

One is through what's called an undefinitized contractual action, or a UCA.

You've heard that term obviously in the past.

We don't care, frankly, how we get the cash.

If it comes under a UCA though, UCAs get funded essentially -- it allows you to bill against the UCA with progress payments.

So we would not recover as much cash under a UCA, although we would still get a significant amount of cash under a UCA-funding mechanism as we would if we actually definitized the contract because, under the LRIP 9 and 10, we would expect to have performance-based payments and performance-based payments where we are on the contract today would actually give us greater cash recovery than would the UCA.

I hope that made sense.

As to impact on margins and so forth, I wouldn't expect one or the other to have any impact whatsoever on the margins we are negotiating.

The only sort of economic impact that we are seeing, and we have raised this with the government, is depending on how long this shortfall lasts, and I gave you some numbers relative to the shortfall, we could be -- if we choose to fund and again avoid the disruption of particularly the supply chain on the program and the international partners on the program, if we chose to fund -- we probably would have to get in the commercial paper market, bigger than we are and that's not something we look forward to and that's probably something that we would have to have a conversation about what's equitable if in fact that takes place with the government.

So potential for a negative on the commercial paper, but we would expect that there potentially could be some consideration for that if in fact that's what happened, but that is not our plan, as I said.

Kat, this is Jerry.

I think we've come up on top of the hour here, so I will turn it back over to Marillyn for final thoughts.

Thanks, Jerry.

Well, as we conclude the call today, I want to wrap up again by highlighting that the Corporation completed an exceptional quarter and we continue to build on our year-to-date momentum.

With an increasing DOD budget and a robust backlog, the Corporation is positioned for top-line growth and strong cash flows in the future.

Thank you again for joining us on the call today and we look forward to speaking with you in our next earnings call in October.

Kat, that concludes the call for today.

Thank you, ladies and gentlemen, for participating in today's conference.

That does conclude the call.

You may all disconnect.

Everyone have a great day.