諾斯洛普·格拉曼 (NOC) 2005 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Northrop Grumman second-quarter earnings conference call.

My name is Anne-Marie and I will be your coordinator for today.

At this time, all participants are in listen-only mode.

We will be facilitating a question-and-answer session at the conclusion of the 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.

Welcome to the Northrop Grumman's second-quarter 2005 conference call.

We provided supplemental information in the form of a PowerPoint presentation that you can access our Investor Relations website at www.northropgrumman.com.

This is available as an accompaniment to our conference call.

The presentation will be available for a limited time and should be viewed in conjunction with today's commentary.

In addition, we are filing our second quarter 10-Q simultaneously with this conference call.

Before we start, please understand that, as shown on slide 2, some of the matters discussed on this call constitute 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 of the Company may vary materially from the results expressed or implied by the forward-looking statements.

A more complete expression of these risks and uncertainties are contained in the Company's SEC filings, including the Forms 10-K and 10-Q, among others.

During the call, we will discuss second-quarter results, including a non-GAAP measure for total segment operating margin, which is reconcile on Schedule 2 of our press release.

We will also discuss the outlook for 2005 and 2006.

Guidance will include GAAP measures of sales, operating margin, earnings per share from continuing operations, and net cash provided by operations, as well as a non-GAAP measure for segment operating margin.

On the call today are our Chairman and CEO, Ron Sugar, and our Chief Financial Officer, Wes Bush.

At this time, I would like to the call over to Ron, whose comments are outlined on slide number 3.

Good morning, everyone.

Thanks for joining us.

This was a very strong quarter across the board.

Earnings per share increased 22% over last year, the main driver being broad-based improvement in operational performance.

Operating margin increased 25% on sales growth of 7%.

Operating margin rate expanded to 7.7% from 6.6% last year.

This 19% increase in segment operating margin was the main factor in the improvement.

All our segments posted higher sales.

Five of the six generated strong double-digit margin increases, which translated into a total segment operating margin rate of 8.3%, an increase of 85 basis points over last year.

Second quarter cash was also very strong at $813 million, underscoring the quality of our earnings.

I would like to briefly discuss our segment performance now.

Integrated Systems and Electronic Systems both posted double-digit sales and operating margin increases.

Integrated Systems grew by 24%, with the drivers being development programs like JUCAS, F35, E-2 Advanced Hawkeye, and the EA-18G.

Electronic Systems sales rose 11%, due in part to higher sales of airborne surveillance and biodetection systems.

We also had significant margin expansion at Mission Systems, Information Technology, and Space Technology.

In Mission Systems, the improvement came largely from improved performance on the ICBM program.

Information Technology's margin rate expansion was driven by better performance in our Government Information Technology business area and Space Technology generated improved performance primarily in the Missile and Space Defense business area.

Ships' second quarter operating margin was essentially unchanged.

Unfavorable margin impact due to the restructuring of the DD(X) program and lower margin performance on LPD were offset by favorable performance on Aircraft Carriers.

LPD, which is a cost-plus program, experienced schedule extension and cost growth, which is not unusual for ships of a new class.

The LPD is a powerful, complex warship which will deliver superior capabilities to the Navy's expeditionary forces.

LPD-17 San Antonio, which is the lead ship of the class, has now completed acceptance trials and has been delivered to the United States Navy.

We are working closely with the Navy on the remaining ships to ensure the success of the LPD program going forward.

Looking across our portfolio, most of our key programs appear to be well supported in the Congressional budgeting process.

We expect that our programs will fare well in the 2006 budget as we move toward finalization of that budget in the fall.

We have also had several substantial new business opportunities.

We were selected by the United Kingdom's Ministry of Defense as the preferred bidder to provide the maintenance and design engineering support services for the Royal Air Force fleet of E3D Sentry AWACS aircraft.

This program represents a $1 billion opportunity.

We expect to announce contract details next month.

We and our teammate Boeing were selected to compete for NASA's Crew Exploration Vehicle program, which is the multibillion dollar successor to the space shuttle.

The NASA Authorization Act was recently approved by the House, which will allow NASA to proceed with its plan to award this program to a single contractor team in early 2006.

We are also pursuing the Department of Energy's Nevada test site management contract.

This is a five-year multibillion dollar opportunity with follow-on options that is expected to be awarded soon.

The Joint National Integration Center, or JNIC, for the Missile Defense Agency is currently in source selection.

We are the incumbent on the predecessor program.

Based on historical funding, JNIC is a potential $1 billion contract that is expected to be awarded this November.

Another multibillion dollar opportunity is the transformational communications satellite systems' mission operation system, also known as TMOS.

This 10-year program is expected to be awarded in the fourth quarter, and will manage communications over the transformational satellite network.

And today, the Navy awarded Northrop Grumman a five-year $208 million contract for the East Coast/West Coast tactical training ranges.

This combined award rounds out our portfolio of providing live training support for the Navy along with the constructive training we do for joint Army, Air Force, and Federal customers.

In addition to the opportunities in our core national security markets, we also have upcoming competition in adjacent markets, like state and local Information Technology.

One example of this is the upcoming State of Virginia IT outsourcing contract, which is expected to be awarded in the fourth quarter.

Based on our strong first-half performance, we have increased our 2005 guidance.

We now expect 2005 EPS to increase by approximately 30% over 2004 to between $3.90 and $4 on a sales basis of 31 to $31.5 billion.

This includes the $0.23 per share gain from this year's equity sales.

We continue to expect cash from operations to increase to between 2.2 and $2.5 billion.

In 2006 we expect earnings per share of $4.10 to $4.30.

Reflecting the full impact of the restructured DD(X) acquisition strategy, we expect sales of approximately $32 billion in 2006.

We continue to expect cash from operations of approximately $2.5 billion in 2006.

I would like to recognize the upcoming retirements of two segment presidents at Northrop Grumman, Bob Iorizzo of Electronic Systems, and Phil Durr of Ship Systems.

We owe a debt of gratitude to Bob for his 43 years of dedication to this Company and to our industry.

He will be succeeded by Jim Pitts, the head of the Airborne Systems Organization within Electronic Systems.

In Jim Pitts' 32 years with the Company he has distinguished himself as a capable and talented executive.

Phil Durr will also be retiring at the end of the year, and we greatly appreciate Phil's contributions to Northrop Grumman.

His leadership has been instrumental in moving Ship Systems forward.

Phil Teel, who is a seasoned executive with a proven track record of managing large-scale, complex integration and manufacturing programs, has assumed the Ship Systems presidency effective July 1.

Both Jim Pitts and Phil Teel reflect the depth of management and bench strength we're fortunate to have here at Northrop Grumman.

Stepping back from this quarter for a moment and looking over the past two years, Northrop Grumman's management team has generated a record of higher margins, earnings, and cash.

Since the second quarter of 2003, our segment margin rate has expanded 104 basis points and total operating margin has expanded by 183 basis points.

Earnings per share are up 85% and our net debt to total capitalization is down from 30% to 18%.

Our balance sheet and credit profile are also much stronger than they were two years ago.

We've dramatically improved our risk profile, with the seamless integration of TRW, the retirement of the $1 billion B2 tax payment, and the monetization of the TRW PIK Note and much of the TRW equity.

We have initiated the enterprisewide ACE initiative to drive operational improvements.

We have demonstrated disciplined financial stewardship.

Our acquisitions have been modest.

We have generated more cash divesting noncore businesses and investments than we have spent on acquisitions.

Cash distributed to shareholders through share repurchases totals nearly $1.5 billion, and during this time we have increased the dividend by 30%.

So going forward, you can expect additional margin rate expansion, continued growth in earnings and cash, and disciplined financial stewardship driving a balanced cash deployment strategy.

This is a management team focused on performance.

Now I would like to turn the call over to our Chief Financial Officer, Wes Bush, for a more detailed discussion of the numbers and the outlook for our businesses.

All right.

Thanks, Ron, and good morning, everyone.

My comments today begin on slide 4, with segment operating margin.

As Ron discussed, our focus on performance is making a real impact.

Year-to-date, our segment operating margin rate is 8.4% versus 7.6% last year, and we are on track to achieve our segment margin rate expansion for the year.

Total operating margin rate year-to-date is 7.9% versus last year's 6.4%.

I will give you a brief update on each of the segments.

Beginning with Electronic Systems on slide 5, for the quarter margin rose 43% on a sales increase of 11%.

Year-to-date, margin is up 21% on a sales gain of 6%.

The second quarter last year included a $60 million charge for Block 60, partially offset by several contract closeouts.

Regarding Block 60, we've built more than 80% of the hardware on the program.

All the radar hardware is finished and we are more than 75% complete on the Falcon Edge hardware.

Our flight test program is ongoing.

We continue to believe we are well positioned to support Lockheed's delivery schedule.

On Wedgetail, proving out of the hardware design is progressing well.

The radar is currently installed on two aircraft and we're in the early stages of developable testing and valuation.

Production continues on an accelerated schedule.

Both programs are performing within our established reserves.

For 2005, based on first-half results, we expect sales in ES to grow at a mid single digit rate versus our prior guidance of high single digit, and we are increasing our estimated margin rate for 2005 to the mid to high 10% range.

Moving to slide 6, Ships' second quarter operating margin increased 1% on sales growth of 2%.

Year-to-date operating margin is up 10% on sales growth of 3%.

For the year, our sales guidance for Ships is unchanged.

We continue to expect a mid to high single digit sales decline, which means we will see lower sales in the third and fourth quarters than in the first half of the year.

This is primarily a function of lower revenue in the DD(X) program.

We now expect that Ships' margin rate for the year will be in the high 6% range, which represents good margin expansion from last year's rate of 6.2%.

On slide 7, Integrated Systems margin increased 20% on a sales gain of 24% percent in the quarter, and year-to-date margin has increased 18% on a sales gain of 19%.

Based on year-to-date results, we now expect a sales increase of Integrated Systems in the mid to high teens versus our previous guidance of low to mid teens growth.

We continue to expect a margin rate in the low to mid 8% range.

Slide 8.

Mission Systems' second quarter operating margin increased 15% on sales growth of 2% in the second quarter, and year-to-date operating margin has risen 17% on sales growth of 6%.

Margin rate in the second quarter expanded to 7.5% from 6.6% last year.

And Mission Systems' year-to-date margin is 7.2% versus 6.5% at this time last year.

For the year, we continue to expect mid single digit sales growth, but we are raising our guidance for operating margin rate.

We now expect margin to expand to approximately 7% in 2005 versus 6.5% in 2004.

Slide 9.

Information Technology's second-quarter operating margin increased 22% on sales growth of 9%, and year-to-date margin has increased 21% on sales growth of 4%.

Second-quarter margin rate expanded to 6.7% from 6% last year.

IT's year-to-date margin rate has increased approximately 90 basis points to 6.8% from 5.9%.

For the year, we continue to expect sales to grow at close to double-digit rates, with a margin rate in the mid 6% range.

Slide 10.

Space Technology's second-quarter operating margin increased 13% on sales growth of 5%.

Year-to-date, operating margin increased 17% on sales growth of 6%.

Space Technology's margin rate expanded to 7.9% versus 7.3% in last year's second quarter, and year-to-date margin rate has expanded to 7.5% from 6.8%.

For the year, we are increasing our guidance for sales, expecting Space Technology to be approximately even with last year versus our prior guidance of a single digit decline in revenue.

We continue to expect a margin rate in the low 7% range.

So looking at the expected results of the segments, we are on track to achieve our segment operating margin guidance in the low 8% range, but with a slightly different composition.

Looking at consolidated operating margin on slide 11, unallocated corporate expenses declined to 42 million from the prior year's 47 million.

Year-to-date, unallocated expense totaled 69 million; however, we still expect unallocated expenses of approximately 200 million for the year due to the timing of several unallocated expense items.

Our CAS pension estimate for the year is unchanged at 415 million, but we have increased our cash pension estimate to 395 million from 375 million.

Net interest expense for the quarter was 69 million lower than last year, reflecting a lower debt level and interest income recognized for estate tax refund related to R&D tax credits.

For the year, we expect net interest expense of approximately 320 million.

The effective tax rate for the second quarter was 33.9% versus 25.5% last year.

We continue to expect a tax rate for the year of between 33 and 34%.

Moving on to cash, slide 12 provides a reconciliation of net income to cash from operations for the second quarter and year-to-date.

We had a very healthy cash conversion this quarter and we are on track to meet our guidance.

Non-cash adjustments include 187 million from depreciation and amortization and 91 million from pension and OPEB.

A reduction in working capital and other accruals generated 224 million in cash.

Taxes and all other items were a use of 56 million, creating total second quarter cash from operations to 813 million versus 610 million last year.

Capital expenditures for the quarter, including capitalized software costs, were 149 million.

Year-to-date, cash from operations was approximately 1.1 billion and capital expenditures totaled 346 million.

We are on track to meet our guidance of cash from operations of 2.2 to 2.5 billion, with capital spending of 750 to 800 million.

During the first half of the year, we also generated about $200 million from the sale of investments and businesses, as we continue to shape our portfolio to improve shareholder value.

Our deployment of cash has included in the repurchase of more than $0.5 billion worth of our stock, 176 million in dividends, the $313 million acquisition of Integic, and 346 million in capital expenditures.

Overall, we think the year-to-date financial results and our cash deployment demonstrate our focus on performance, as well as our commitment to a balanced cash deployment strategy.

Slide 13 summarizes our 2005 and 2006 guidance.

As you can see, we continue to drive robust expansion in our margin rates.

We are increasing our expectation for total operating margin rate to expand to the mid 7% range in 2005 from 6.7% in 2004, and to approximately 8% in 2006.

We have increased our guidance for 2005 earnings per share from continuing operations to a range of $3.90 to $4.00, including the $0.11 gain on our third quarter sale of Endwave stock.

The increase also includes the impact of the increased CAS pension projection for 2005.

For 2006, we expect earnings per share to grow to between $4.10 and $4.30.

This is a solid increase over 2005 EPS, adjusted for the $0.23 per share from the TRW equity and Endwave stock sales.

And as you saw from the press release, the Board approved accelerating the vesting of all outstanding unvested employee stock options, excluding elected officers, effective September 30 as part of an ongoing evaluation of the Company's overall incentive compensation strategy.

The amount associated with the decision to accelerate vesting is being charged over the new vesting period and is not significant.

Our updated 2006 guidance includes an estimated pretax expense of about $12 million, or about $0.02 per diluted share, associated with the adoption of FAS-123R.

We have also assumed that net pension expense will be the same as 2005.

Of course, actual 2006 pension expense may vary depending on a variety of factors.

And cash from operations is expected to be between 2.2 and 2.5 billion in 2005, and should be approximately 2.5 billion in 2006.

We are continuing to demonstrate our focus on performance and we are on track to achieve our financial targets.

We would now like to open up the call to questions.

(OPERATOR INSTRUCTIONS) Byron Callan, Merrill Lynch.

Nice quarter, gentlemen.

I will stick with the big picture so other people can get into details.

But, Ron, Lockheed Martin had mentioned on their conference call that they too were focused on attracting and retaining the best employees.

And since this is now becoming more of an industry thing, can you elaborate on what you think Northrop Grumman is doing differently to be the employer of choice in this sector, and how you link that creating shareholder value for the Company?

Sure, Byron.

Thanks for the compliment on the quarter.

Listen, we are working very hard on that.

We believe that the human capital is the differentiator in this business, because while we build a lot of stuff and deliver stuff, it is the quality of the people and the engineering that makes the difference.

One of things which differentiates Northrop Grumman is that we are a company capable not only of large-scale system integrations, but also deep technology focus in those areas where there is enabling technology that makes a difference to the market.

So we find ourselves able to attract young folks who have technological skills because of the very interesting work that is being done in this Company, as well as work that they get to do in terms of systems.

So we are very much focused on that.

We do have folks in lab coats, as well as people who can do broad scale systems engineering integration.

We hired nearly 20,000 people last year.

We focus very hard on college hiring.

We focus very hard attracting really high-caliber college hires who are both minorities and women.

More than 54% of our college graduates were minorities and women last year.

So this is obviously a competitive area for us.

We put a lot of attention in it.

Okay.

And then the follow-up, any of the margin improvement, can that be attributed to ACE?

Yes, I think so.

We are beginning to see some early signs of that.

And as we had indicated, we have wrapped into our total guidance we're giving for this year and next the integrated effects of the ACE activities.

So while I am not prepared to break out anything specifically, I will tell you we are already beginning to see some effects of it.

Great.

Thank you.

Joe Nadol, JP Morgan.

My question is in the shape area on the carrier contract.

Noted that you attributed better performance there to offsetting LPD 17.

Can you say whether there was an EAC adjustment and put any kind of bracket -- size any kind of way?

Yes, I can say that broadly we look across all of our programs on a very routine basis.

We did have some EAC adjustment, some benefit on Eisenhower in particular, as we looked at the overall performance in carriers.

So that was certainly a component of the improved performance there.

Okay.

And for my follow-up, you lowered your electronic sales a little bit.

Is that mostly international slipping or is it something else in there?

You got it right.

That is exactly it.

It is primarily a reduction in our forecast for international sales for this year.

Any color on that?

No, I think it is just sort of the integrated effect across the variety of international business that we have.

There isn't any one thing in particular that stands out.

Thank you.

George Shapiro, Citigroup.

My question is, I wonder why you didn't increase the guidance more.

Because effectively, if you incorporate your $0.11 per share gain for Endwave, which is new, and you added $0.04 a share from additional CAS recovery, that $0.15 accounts for all of your increase in guidance, and yet this quarter was generally somewhat stronger than expected out there.

So what is weakening in the second half of the year relative to second quarter?

George, if you look at our guidance, it does reflect our best view, our best thinking today of the second half of the year.

But there are a couple of timing related issues, one of which you pointed out, that if you look at the total year, we have seen the $0.12 gain on the sale of TRW and there is about $0.11 on the sale of the Endwave equity.

So you have to take that out of the total and look at the result associated with the operating performance.

I would say one of the biggest issues associated with timing is the unallocated that we expect for the year.

We expect a total impact of about $0.40 per share, and we have only seen about $0.14 of that during the first half of the year.

So that is a component of that differential.

But we do expect the business to continue to operate very well and reflective of the strong second quarter that we have seen.

I guess what I am asking, Wes, is the $0.11 per share gain from Endwave is something new.

And so the guidance has gone up $0.15 and $0.11 is now Endwave and $0.04 is the $20 million increase in CAS.

So I guess the only thing I can come up with is what you just mentioned, it is just the higher unallocated in the second half, and if you could comment as to why it is going to work out that way.

Again, I think you briefly hit on it, but I missed a part of it.

There is simply a variety of expenses that we incur over the course of the year and we are expecting some of those expenses to be more heavily loaded, some of the unallocated expenses to be more heavily loaded in the second half.

Relative to the overall operating performance, our total segment operating margin guidance remains the same as we gave at the beginning of the year, and we believe this is reflective of what we're seeing right now.

And just my follow-up.

In Electronics, the margin was somewhat higher that what you're guiding to for the year and higher than it has been.

Were there any one-time benefits in that quarter or why does the Electronics margin get worse?

We did have an acceleration of some of the units of delivery items that we had previously expected to be in the third quarter or a little bit in the fourth.

We succeeded in accelerating some of those into the second quarter, so there is some benefit.

But if you look at the guidance for the year, we have established a mid to high 10% expectation for performance in ES for this year.

So we are expecting improvement relative to the guidance we had given previously.

But there is nothing really extraordinary than in the fact that this quarter was 11.2?

No, I would not describe it is as extraordinary.

Just timing.

Yes, there was some timing associated with units of delivery.

Okay, thanks.

(OPERATOR INSTRUCTIONS) Cai von Rumohr, SG Cowen.

Good quarter.

Shipbuilding, a couple of things.

Could you quantify the size of the LPD reversal, if any?

And could you get any of that back now that you've delivered the first ship?

Yes, in terms of the actual impacts of performance on LPD, I would characterize that as a relatively small impact in aggregate.

You could see that our overall Ships' margin for the quarter continued to be quite good.

We did reduce our expectation, though, for the year in terms of the operating margin that we expect -- the segment operating margin that we expect in Ships from low 7% to the high 6% range.

And that is largely the effect of the reduced performance in LPD.

Whether or not there might be some upside to that in the future as we proceed with the LPD contract, I think time will tell.

Okay, and I was kind of surprised at the level of volume in Ships, expected it to start to come off.

Is it basically going (ph) to stair step off?

Because if it actually hits your estimate, it's got to stair step off pretty sharply in the third and fourth quarter.

We do expect it to decline in the third and fourth quarter, driven largely by the substantially reduced profile on DD(X).

To point out also, to add, the work on DD(X) that is falling off is work that was largely subcontract work which we had.

And as a result of the Navy's restructuring the program to allow a future potential competition, they have removed from the prime role which we had the management of the Raytheon piece, the gun system, and the integrated propulsion.

So you see a significant reduction in volume of (indiscernible).

I will also tell you that our margin rates on that part of the program were low single digit.

So we have not seen -- will not see a comparable margin impact from that.

But the revenues will in fact stair step down because of that.

So is there any upside to your shipbuilding margin guidance, given that you have some negatives on LPD and the revenues you are moving basically are not high margin revenues anyway?

I would say that as we go through this every quarter, there is always performance upside, if we perform better than our EACs project today.

Okay, terrific.

Good quarter.

Let me also just add, if I could, that there is a lot of focus on shipbuilding of the course.

Shipbuilding accounts for probably less than 1/5 of this Company's revenues.

And if you take a look at the impact of a DD(X), you're talking about a few single digits percent of the sales variation of the Company going forward.

So while it is very important to us and it is something which is of course important to the Navy, the Company's overall plans and fortunes don't rise or fall with the latest assumption of a particular ship program.

A follow-up from Byron Callan, Merrill Lynch.

I will jump back in the queue.

Let someone else -- I've already asked a question.

Thank you though.

A follow-up from George Shapiro, Citigroup.

If I looked at your backlog, it was down in all sectors except for IT.

Could you just go through the detail as to what was going on there?

Let me just start off with --.

That's on a sequential basis, I am looking, Ron.

First of all, it is down very modestly.

It's down, I think 1 or 2%.

And there is going to be significant variation quarter-to-quarter with timing.

Yes, I think that is the key point.

If you look at our typical cycle, the variation over the year, you can see it reflected in the acquisition and backlog numbers for this quarter.

This quarter, if you look at acquisitions as a fraction of our sales, we were about 70%.

That is almost exactly where we were in the second quarter of last year.

That's typically what the third quarter looks like as well, with a very strong fourth quarter, and the backlog tends to track with that.

So there's a substantial seasonality that we see.

George, based on what we see coming out of both the Senate and the House for the '06 appropriations, we are pretty comfortable with the guidance we've given you in terms of revenue and we think the backlog is consistent with that.

Let me just ask a couple of questions, then, because sequentially it's actually gone about 9%.

You had a drop of like 1.2 billion in Ships.

Now does that just reflect this DD(X) restructuring that you were talking about or is there something more there?

That is almost entirely the DD(X) change.

And that's taking out a large amount of the subcontracted work that we won't perform now directly under us.

It will be performed.

The Navy will fund it, but it won't come through us.

And then the other area that was down quite a bit was Integrated Systems, was down around 700 million.

I'm not sure your point of comparison.

Were you looking back to this time (multiple speakers)?

No.

Just looking sequentially, it's 5.3 billion at the end of Q1.

Now it is 4.6 billion.

That's just burn off of the backlog they had.

That is pure seasonal variation.

If you look the backlog compared to where we were at the end of last year, Integrated Systems is up substantially.

So again, it is just the seasonality of the acquisition cycle.

I would note one other thing also in ES, George.

We did have a sale of a piece of business out of ES, which (indiscernible) the backlog out of there as well.

It was about 200 million reduction in backlog from the sale of Teldix.

Okay.

Integrated Systems year-over-year, my numbers show as about flat, but maybe I got the wrong numbers.

You might have the wrong numbers.

I will tell you we are very excited about both the current situation and the prospects in Integrated Systems.

There is some significant opportunity, and some of the programs I walk through involve them as well.

And then one last one.

On DD(X), if you go back a couple of quarters ago, you were estimating 33 billion for '06 in revenues and now 32.

Can I make the assumption that that is effectively taking out $1 billion of revenues from DD(X) the next year?

That's correct.

When we gave you a 33 billion guidance, we said that that we had up to about $1 billion of potential impact associated with DD(X), depending on the outcome of the Navy's acquisition strategy.

Now that those decisions have been made, that $1 billion has manifested itself in our new guidance.

So what are you assuming now in DD(X) revenues for next year?

It is a fairly small amount at this point, associated with a continuing joint development work that we're doing.

Again, the Navy's decisions on exactly the timing on ramping up DD(X) under the new acquisition strategy could have some impact on that (multiple speakers).

It's also not clear that Congress goes along with it.

That's correct.

I think one thing which is different today than perhaps a quarter ago, George, is that the Navy has come up on the net very strongly in terms of advocating this program.

There were some questions maybe a couple of quarters ago as to was this program one that might get cut.

I think you're going to see the Navy very strongly advocating it, and I think you're going to see that Congress is going to look to the Navy for a cue on this thing.

And we will see how it all plays out after the recess, but we believe there is going to be a program and we believe that it is certainly going to involve us.

Ron, your assumption is that the Navy plans goes through Congress at this point?

We will see how it plays out, but I think that is more likely than not.

Okay, thanks a lot.

That is the way we are contractually directed right now.

Eric Hugel, Stephens Inc.

Good quarter.

Maybe just to follow up on another way to think about the DD(X) potential here.

Is it pretty safe to say that looking out into '06, most of the DD(X) risk to your guidance is now gone?

Yes, I think that is exactly right.

You can never say never, but I wanted to make the point earlier -- I'll repeat it again -- that while it's an important program for us, it is not a huge, huge fraction of our revenues.

And the variability on what we would expect has got to be in the very low single digit percent in terms of our revenue guidance.

The way you said it is exactly right.

The sensitivity, if you will, to DD(X) in our guidance has been eliminated.

My second question is regards to Information Technology, you estimate 9% growth in that business.

How much of that, what percentage of that growth is organic?

I am assuming there is a chunk of that from Integic.

Yes, about one-third of that amount of growth is Integic and about two-thirds is organic.

Thanks a lot.

Heidi Wood, Morgan Stanley.

Nice numbers.

And I am going to claim the right to ask a question on Ships suffice, since I so infrequently do, so I am sorry about that in advance, Ron.

Only this time.

But it pertains to something that I have seen over time, which is Heritage/Avondale was infamous for having performance issues.

And while you talked about the LPD-17 having glitches that were clinical and not unusual for a ship of its class, in fact, I believe you got very low grade from the customer on that first delivery.

And what I would like to hear from you is sort of your thoughts about what you are doing about the quality control processes in place, particularly at Avondale.

What have been trying to do, what has not been working and where you going from here to change that, so we can hopefully start to see better execution out of that shipyard?

It turns out it is not quite as simple as that anymore.

We have taken significant steps to integrate the operations of the former Avondale and the former Ingalls shipyards.

So if you take a look at the current LPD program, it is being co-produced in both yards.

Some units are being produced in one yard, others in the other.

And the first ship was assembled at Avondale but sent over to Ingalls for final integration and tests, or final tests and checkout sea trials.

We put a tremendous amount of effort through ACE and another effort which we call locally True North, which is our own process improvement activity down in the shipyards in the South, so we are working hard on that.

One of the things we have had to do over the years is to upgrade the older systems which Avondale had, and also frankly adding capability to the systems which Ingalls had.

These are basically production control systems, management control systems, and what have you.

So it is a continual process of improvement.

A lot of management focus is going into the program, and we are comfortable going forward that we're going to see improvements.

Despite some of the issues, this particular ship had fewer starred trial cards -- those are the ones that are important -- than any first-of-class ship in memory down there.

And while there are many, many punch list items, these things are routine.

They get cleaned up.

We're expecting the crew to move aboard shortly.

We're expecting to have a nice commissioning in late October or early November.

So we're making progress, and we have four more ships in process behind them.

Each one is getting better.

Then to turn to a much broader picture question for you then, Ron, can you talk to us about what you're seeing in terms of the marketplace for M&A?

Can you give us some color on the pipeline and contrast versus last year, both in terms of maybe number of properties that you're looking at, average size as well as average price?

Yes, that would be great.

I don't think I would comment specifically on properties or price.

I think I would go back to what we have said before starting with -- the portfolio the Company has now is very good, and we think we're right where we want to be.

We are going to see some opportunities from time to time to improve that portfolio and divest a few things.

And as I pointed out in my comments, Heidi, we have actually divested more than we have acquired because we thought that was more shareholder value enhancing.

So looking forward, we're going to keep our eye on the M&A market.

We have not closed our M&A shop, but we're not sitting here today in a position to say anything specific.

No, I don't want the specifics, but just in terms of -- you have got a lot of cash coming through the pipeline in '05 and '06, and already an attractive net debt to cap.

Should we think about Integic as being the sort of size of deals that you're going to be looking at going forward?

Again, I'm just trying to get a sense, Ron, about how the pipeline is looking?

Is it wider that it was last year or thinner?

I'm not sure there is any change there, Heidi.

I think Integic was a very specific deal with a specific set of strategic and financial opportunities for us that we took advantage of.

Every one of these things we're going to look on a value basis, but I should also emphasize that we're going to be looking and continue to look at all the cash deployment options, including share buyback, dividend increase, and some continuing retirement of some of our more non-economic debt.

Okay, great.

Thanks very much.

Steve Binder, Bear Stearns.

A couple questions.

One is I know a couple people asked about Electronic Systems and the margin improvement perspective for 2005, and Westview also touched on the weaker outlook for international sales, and I suspect some of the weakness you saw in bookings in the quarter was from that region, those regions.

But I'm just wondering, historically it's been a rich mix of business for ES.

You have upped the margin guidance and you've lowered you're international sales guidance, which is roughly about one-third of the business.

So what would you say -- it's obviously performance improvement, where would you point to domestically that is accounting for that improvement?

There's several places, actually, that we're seeing the improvement.

The Government Systems business I think is a really good example of that, the work that we're doing with the Postal Service.

We are hitting the deliveries very effectively, and also that has turned out to be an area where the margin opportunities are quite good.

We have also been doing well in Defense and Navigation Systems and in Aerospace Systems.

Defense and Navigation, on the EO and IR countermeasure sales, those are going quite well, and airborne surveillance sales within Aerospace Systems.

So kind of across the board for three of the larger components of ES, we're seeing very good performance.

And we see good sustainable performance.

Would you characterize the weakness internationally as simply a timing issue.

Do you expect that to recover in '06?

Maybe just touch on that.

It is certainly an impact for the latter half of this year.

How much of that we're going to see continuing into next year, we're not certain at this point.

It does not look like a major factor in our outlook for ES for next year.

And then CapEx, you had a strong quarter in CapEx -- it's up like 80 million for the year.

You're expecting it to be up this year.

Can you maybe touch on what you're expecting for CapEx for the year?

We're still projecting 750 to 800 million for this year, but we're expecting it to decline next year.

And that is consistent with the guidance that we have given out since our investors' conference in March and continues to be our outlook.

Lastly, you had some heavy share repurchase activity, over 300 million a quarter in Q4 and Q1, to offset the effect of the ESUs.

It came back down to like 150 this quarter.

Is this the kind of level of activity you expect to see in the future?

Yes, if you look back at October of last year when we announced our share repurchase program, we said that we would buy back about $1 billion in shares over a 12 to 18 month period.

As you point out, we had a very fast pace to that through roughly January of this year, and then we have settled to really a more constant pace since then.

Maintaining that pace will complete the share repurchases roughly in October of this year.

So we will have gotten it all done within about 12 months of the 12 to 18 month period that we established.

Okay, thanks a lot.

Jared Muroff, Prudential.

I was wondering if you could talk a little bit -- there has been a lot of talk in D.C. in terms of acquisition reform and looking at some of the way that the Pentagon contracts different large projects -- how you think that may affect Northrop Grumman, what you see happening there, and whether or not you think what is happened with the DD(X), where they have pulled out some of the subcontracting work, may be a first kind of stage of that, or if you think that is unrelated.

Well, Jared, let me just address the first part of the question.

Gordon England, who is now the Acting Deputy Secretary of Defense, has constituted a very intense effort to reexamine acquisition process in a very introspective way.

What is that we need to do better?

We will see the results of that probably some time late this fall.

The industry is participating, both individually and through our Aerospace Industries Association.

It is a national challenge.

We all need to find a way to get more bang for the buck for the money spent.

It is too early to say right now how that is going to come out.

At the moment, we don't see any significant or material changes to anything we would guide you with as a result of that.

I would export with the DD(X), I think this was a program decision where it was determined because of the need to eventually compete the two shipyards, it was not appropriate to have one of the shipyards, in this case us, have control of all the other elements of the program.

And it was just an acquisition decision for the benefit of this particular program to protect a down select opportunity, level the playing field.

At some time in the future, the Navy could in fact determine to put these contracts back under the shipyard.

They could continue to do them as an associate contract, as they currently do today, with the DDGs.

The Aegis, as you know, is an associate contract and not a subcontract to us.

I think there is some question around the building and on the Hill about these large-scale integration programs where the prime contractor is basically managing and integrating the work of many other people, and that is getting some scrutiny.

We're not in a position where we have much of that.

We have the ICBM program, which is an important program, and this program has gone for quite a number of years.

It is doing very well.

We do not anticipate any changes in our portfolio as a result of this at the present time.

Great.

And just one quick one.

It looks in your guidance for next year, you have taken down the FAS-123 expense from 80 million to 12 million previous.

I'm just wondering if that reflects a shift in how you're compensating various people or a shift in how you're accounting for it.

Yes, if you look in our press release, we've announced today that our Board has decided to accelerate the vesting of unvested stock options for employees, other than elected officers, and that largely accounts for that differential.

So you expense the options when they vest, not when they're issued?

That is right?

That is why you're able to take that charge?

You take that hit down before 123?

Yes, they will basically all the vested at this point, with the of the exception of the elected officers, and so we will account for that over the period, which as I said earlier is really not significant and will not be a factor for next year.

But won't you be issuing options next year?

Don't you have to take the expense on the options you issue next year?

Only for elected officers.

And that won't be significant compared to what we had before for the broad class of people.

And that's around the 12 million number that we include in our guidance.

I would add, just so you know, that we're going to continue to incentivize everybody with respect to the stock because of the restricted performance shares, which is not only issuance of restricted stock, but also has a performance indicator on it.

And the payout for the population of people eligible will depend upon how we perform and the metrics we use are largely driven by shareholder value.

Great, thank you.

Pete (indiscernible), Credit Suisse First Boston.

I'll apologize in advance because I just want to belabor the LPD-7 on more time.

Speculation is that postdelivery, there's going to be substantially more work to do on the ship for repairs or whatever you want to characterize it.

I was just wondering if you, along with the Navy, have you gotten a cost estimate in terms of how much additional work is needed.

And if so or if not, your share of that, will you potentially have to -- does it -- I guess the correct question to ask us does that represent potential risk to your margin in Ships?

The answer is no.

We work very closely with the Navy.

We are always in the process of assessing our estimates to complete on this cost-plus program.

And while one never wants to see cost growth on a first-in-class ship, the fact is that we have this.

We're working carefully to finish out what has to be done.

I think what you're seeing in terms of our guidance, we don't see significant risk in that at all.

Okay.

Second question is, you had a big press conference in D.C. on the Los Alamos bid and then decided to withdraw from that.

I just wanted to ask you why you decided to no-bid Los Alamos and isn't this kind of a big opportunity to miss?

Pete, it turns out the when the final RFP came out, the economics on the bid, the opportunity for us was not consistent with what we wanted to see in terms of business case, and we did not feel that there was a value creation in proceeding on it, and we determined to not bid.

Okay.

I guess lastly, I noticed that you did quite a reorganization in Electronic Systems, and I know you have talked about it a little bit.

But I was wondering if you could just mentioning again, sort of at a subunit level, what you see as the big growth opportunities on a subunit level within ES.

We have not had a reorganization in Electronic Systems.

We've announced a succession to an individual retiring.

Be a little specific of what you're looking at?

I know -- it seems like you have combined the defense and the navigation sections, kind of broke out (multiple speakers).

In terms of our reporting organization (multiple speakers).

We have aggregated for reporting purposes that, more consistent with how -- but I think that was something we did at the beginning of the year and we had really had a senior executive running a couple of those divisions together as an entity.

So we just reported it that way.

Okay, thank you.

Howard Rubel, Jefferies.

Nice sale on Endwave.

And sort of to follow up on that, you should have goodwill attached to that, so most of this is going to be cash proceeds we will see in the second half of the year.

This is cash.

There is some gain.

I mentioned earlier it is about $0.11 per share.

The basis should be very low because I think (multiple speakers) --

Yes, absolutely.

Well, just to follow up, you have been going through the portfolio and doing a nice job of selling noncore assets or peripheral assets.

At some point, Wes and Ron, do you go back and when do you really decide that the share repurchase program ought to be expanded?

I think you said you're about at 80% done at the moment (multiple speakers).

Absolutely.

I mentioned earlier that if we stay on the pace that we have been on now for several months, we're actually going to wrap this 12 to 18 month program up in a 12 month period.

So we will be done roughly in October.

And while we don't preannounce programs on buyback, we have been very public in saying that it is our intention to regularly review our share repurchase authorization as part of our overall balanced approach to deployment of free cash, and I think you should continue to have that expectation from us.

I think we're on the same page.

Just to finish on this -- there are probably some additional assets that you found as you've gone through the portfolio that you feel like you can probably harvest.

Is that reasonable?

We're not going to cite specific businesses, but we are right now in the process, as part of ACE, of looking at maybe 100 of different business elements as we divide our Company up, and taking a very careful look from a shareholder value standpoint of are there any that would be more valuable to somebody else than to us, given those strategic intentions.

So I would not be surprised if you might see in the future some continuing divestitures, but we have nothing specific to queue up at this point in time.

Well, your actions sort of speak in that direction.

We're continuing to look at ever one of these businesses from the standpoint of what kind of value is worth to us and our shareholders versus what is it worth to somebody else.

And if it is not strategic to our central approach to the future, then it is going to be something we're going to look at selling if we can get the right price for it.

Sounds fair.

Thank you.

Joseph Campbell, Lehman Brothers.

The results have been terrific and I know the Company is dedicated to shareholder value, which for us means making the stock go up.

And yet the Northrop Grumman stock seems to be stuck here for awhile, lagging the group, and on all the metrics that we can measure, it looks very, very inexpensive.

And I wondered if this is just investors fixating on all the various news and uncertainty about ships?

Or do you think have a view about what is going on here and if it is just a temporary kind of misperception about uncertainty or risk associated with ships that you don't share?

Why not really step up the stock repurchase program, because apparently that would mean that the share price is priced wrong.

Joe, those are good questions, and in some sense you're talking to Rodney Dangerfield, who is kind of wondering why the stock doesn't get any respect.

I will tell you, if you take a look at the performance of the Company over the last couple of years, we have really significantly taken this thing up to the next level.

All of our metrics -- our cash, our earnings, our growth, our margin expansion -- are there.

We're doing everything we know how to run the Company correctly.

We're being responsible stewards of the capital.

Clearly, it is up to the marketplace and those of you who guide the marketplace to make judgments on our relative value.

I think your comment about the share repurchase is a good one, and I think I would go back to Wes's earlier comment, not go beyond that at this point in time.

Clearly, we think that the Company has tremendous prospects going forward.

We would like to just keep doing it, and that's our plan here.

And then you all will have to decide how you value us.

Joe, this is Gaston.

I would add to part of your question there, a good 80% of the questions we get relate to that 20% of our business you're talking about there, okay?

And yes, I believe there is a fixation.

Yes, I think there is almost an irrational fixation, perhaps.

And of that 20%, less than 10% of it is on the part which is in potential play -- probably only 5% or less.

Half of the 20% is our nuclear business, which is long-term contracts on both carriers and submarines, and that is proceeding.

And our guidance includes actually building those things on multiyear programs and continuing it one submarine a year on the submarines.

On the Surface Combatants, we have significant Surface Combatant work which is continuing for the several years on the DDGs.

What is on the margin is what potential upside at this point in time or maybe downside -- but probably more upside than downside -- we will see -- on the DD(X).

And I told you that that is probably a couple of percent or less of the revenue variation in the Company going forward.

So there is a massive fixation on something which seems to be the wrong end of the telescope.

But obviously, if that is what our owners are concerned about, we're going to continue to share with you what we know about it.

Meanwhile, we have projected improvement in terms of performance and margins in that business.

We're putting a lot of energy in there from a management standpoint, and we see it as a long-term business.

It is a very important set of businesses for the Company and the nation.

I will also tell you that there is a general feeling out there that maybe we don't a Navy.

I will you that feeling is probably not going to prevail.

The Congress feels very strongly we need a Navy, we need a powerful Navy; and a powerful Navy needs very capable warships.

So we're dealing with a long-term play here.

So while we will watch some of the variations that have gone on in Congress and with the Navy department, I think you're going to see things sorting out here soon and we are going to stick with it here.

Just one more thing on the share repurchase generally.

It appeared that the announcement you made before was primarily motivated by offsetting the dilutive effects of the securities that were sold in 2001 or so, or in association with various acquisitions.

And a lot of the companies talk about returning value to shareholders or cash to shareholders, but when you look at the bottom line, really all that is going on is we're giving employees stock compensation and then we are generating cash flow because doing that doesn't cost any cash and then we use the cash to buy the stock back.

So you don't really reduce the share count.

And I wonder when you talk about share repurchases, whether you actually have in mind to reduce the share count beyond the dilution that comes from either securities previously issued or compensation that is an ongoing part of the Company's package.

As we are looking at our next steps in share repurchase, one of our key considerations is the degree to which we would be interested in actually taking the share count down.

If you look at the repurchase amount necessary to offset employee options and employee shares, that is only a few hundred million dollars a year.

And as we think about our range of opportunity, certainly we have more substantial opportunity for repurchase than that.

So we have not made any formal decisions, but it is a thought process that is underway.

Thank you very much.

Doug Harned, Sanford Bernstein.

I wanted to talk not about ships.

I wanted to talk about IT.

And the first half of the year, you have gotten up to some very good margins relative to history.

And one question I had is how much of this -- I know you've talk about growth in government Information Technology, but how much of it is growth in task specifically?

And then why, given your guidance, would we expect lower margins in the latter half of the year?

Task has been growing very well.

And so while we have been talking a lot about a variety of components, clearly task is a strong part.

And by the way, we do report task as a part of government Information Technology.

And so we should not give any short shrift to specifically calling it out because it's been doing very, very well.

In terms of the operating margin, if you look at it year-to-date, the first six months, about 6.8%.

And our guidance for the year is around mid 6%.

We're expecting to see some growth in sales over the latter half of the year, and there is a little bit of a mix issue associated with the margin rates on that growth component.

But we are continuing to expect very good margin expansion for the year in IT, so we're quite pleased with the progress that the business is making.

And can you say when -- the mix issue, is there a specific area you are expecting that growth to be in?

No, it is fairly broad across IT, across the different reporting segments.

And then my second question is (indiscernible) biodetection, can you talk about how large that business is today and what your thoughts are on growth going forward?

That is largely within the Electronic Systems sector, as you know, and one of the things we described a little bit earlier today was the growth that we have been seeing.

It is reported within what we call the Government Systems business in Electronic Systems.

And we are showing about 25% sales growth year-over-year in that component of the business.

We are projecting that it is going to continue to grow healthfully into next year.

Okay, great.

David Strauss, UBS.

I apologize for the ship questions in advance.

Obviously, the Hill is looking pretty hard at Deepwater.

Could you touch on your performance -- I guess the teams' performance -- on Deepwater relative to the expectations in terms of cost and schedule?

As you know, Deepwater is an alliance between ourselves and Lockheed Martin.

We're working closely as partners on this program.

Our portion of the program involves the ship assets.

Lockheed provides the airborne and (indiscernible) SR assets.

I think the issue on the Hill is not so much a matter of do members of Congress want or not want Deepwater.

I think everybody firmly believes we need to have it.

The Coast Guard needs it.

It's a key element of Homeland Security.

I think the challenge has been the House side, where the question has been one of communication between the Coast Guard and the committee that oversees this in the House in terms of long-range plans for Deepwater, given the size of the program, and getting clarity on that.

And we're going to see an interesting conference in the fall.

My expectation is that at the end of the day, we're going to have strong support for the program.

Certainly, as we proceed on the program, we're making good progress.

We're involved now in the first two national security cutters, and from our perspective, the ships are designed.

They are already starting construction, and we are proceeding on them.

I think at this point in time, there is not much more we could report.

I think the real issue is the macroscopic issue of kind of establishing about what the level of funding is going to be from the Congress and the amount of oversight the Congress is going to want to put on the Coast Guard department to make sure they have this visibility they need.

Okay, great.

Thanks.

Could you also touch on what you're doing as far as on the small ship side of things now?

Obviously, the Navy talked to Paramount about LCS and also making additional purchases in the small ship area.

After not being selected for LCS, could you give us an idea of what you are focusing on the small ship side?

We really are not structured to attack the small ship market, and it also turns out to be a much smaller market from a dollar standpoint as well.

We are overseeing all three classes of Coast Guard vessels, which do include the smaller -- the fast response cutters and the offshore patrol cutters, although we do not build the hulls for the smallest one; they will be subcontracted out to another yard that is more appropriately capitalized for that.

So we are not actively promoting at this point in time a small ship strategy.

We know the role we have to provide the major warships.

Okay, thank you.

Miles Walton, CIBC World Markets.

Good quarter.

Kind of a top-level question.

The homeland defense market has been something of nebulous to most of the primes, certainly fragmented.

I'm just wondering with the new chief in their, kind of the London affects, the (indiscernible) with one of the legs focusing on homeland defense, are you seeing a firming in the picture of where that landscape is going to fall out and where Northrop fits in?

I think this is going to continue to be an evolving story.

I will say that we're doing probably north of $0.5 billion a year related to Homeland Security now.

I don't have the exact number off the top of my head.

And that is largely involved in the Deepwater program.

We're doing work in biotoxin screenings for post office.

We're doing work in the Homeland Security data network.

We're doing work in the Homeland Security's information systems.

And we're doing work in infrared countermeasure systems to protect commercial aircraft.

So we see that as a promising set of future opportunities.

Certainly, without a crystal ball here, I can't tell you where all that is going.

I will tell you, though, that the materiality of the Homeland Security business to this corporation will never be at the same scale as our core defense business.

But it is important and where there are adjacent technologies we can utilize, we are proceeding with them.

Okay, and then just a quick one.

The state of the pension plan performance to date, I know you mark to market the performances -- it tends to be a little bit more important than peers (ph).

Yes, in terms of performance to date, I think all I would say is that it is consistent with our overall projections for the year and we're pleased with how we're doing.

Thanks.

Let's see, this has been a full call.

We really appreciate your questions.

We also are very pleased with not only the quarter, but the progress we're making overall with the Company, and we really do appreciate your interest and support in Northrop Grumman.

Thank you all and goodbye.

Ladies and gentlemen, thank you for your participation in the Northrop Grumman second quarter earnings conference.

This concludes the presentation.

You may now disconnect.

Have a good day.