諾斯洛普·格拉曼 (NOC) 2007 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Northrop Grumman fourth quarter and year end conference call.

I will be your coordinator for today.

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

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

(OPERATOR INSTRUCTIONS) As a reminder this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr.

Gaston Kent, Vice President of Investor Relations.

Sir, please proceed.

Thanks, and good morning, ladies and gentlemen, and welcome to Northrop Grumman's fourth quarter 2007 conference call.

We've provided supplemental information in the form of a PowerPoint presentation that you can access on our Investor Relations website at Northrop Grumman.com.

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

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

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

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

During today's call we will also discuss our outlook for 2008.

Guidance will include GAAP measures of sales, operating margin, earnings per share from continuing operations, cash from operations, and non-GAAP measures total segment operating margin and free cash flow.

Just to advise you, there is an updated release which will go out shortly correcting a transposition on schedule 1 of the release.

In that schedule net income is shown as 1.709 billion.

The correct number as is displayed actually in the release is 1.790.

It is a simple transposition of those numbers.

The 8-K filing which went to the SEC this morning is correct.

We also wanted to draw your attention to schedule 6 of our earnings release which provides an adjustment of 2005 through 2007 results reflecting the transfer of a small organization from electronic systems to mission systems which became effective January 1.

Schedule 6 is provided so that you can adjust your models prior to the first quarter.

On the call today are our Chairman and CEO, Ron Sugar; our President and COO, Wes Bush; and our Chief Financial Officer, Jim Palmer.

Please go to slide three, and at this time I would like to turn the call over to Ron.

Thank you, Gaston, hello, everyone, and thanks for joining us to discuss our fourth quarter and full-year results.

This was an outstanding finish to 2007 which was a record year by every key measure.

Sales topped $32 billion, segment operating margin increased 11% to $3.1 billion, or 9.7% of sales, operating margin grew 22% to more than $3 billion, and EPS rose 16% to $5.16 per share.

Cash from operations reached a record $2.9 billion with free cash flow exceeding $2 billion.

We also increased our total backlog by $3 billion to an annual record of $64.1 billion.

We continue to build on and strengthen the positive trends we've demonstrated over the last several years.

To put this year's results into perspective, since 2003 the first full year following our last major acquisition, operating margin has more than doubled, operating margin rate has expanded 360 basis points from 5.8 to 9.4%, earnings per share have increased by nearly 250%, and cash from operations has more than doubled.

We continued to deliver on our commitment to improve performance.

The strength of our financial results allowed us to take several shareholder value enhancing actions during 2007.

We increased the dividend by 23%, the fourth double-digit increase in as many years, and an 85% increase since 2003.

We repurchased 15.5 million shares of our common stock for $1.2 billion during the year.

Our Board recently authorized a new $2.5 billion share repurchase agreement, our largest to date, representing approximately 9% of our shares outstanding.

During the year we also invested for the future with acquisitions of Essex Corporation which has enhanced our capabilities and participation in the rapidly growing intelligence business as well as acquisitions of Scaled Composites and Xinetics.

Along with executing our balanced cash deployment strategy we improved our net debt to total capital ratio to 14%, achieving the highest credit rating in our Company's history.

One of the highlights during 2007 was new business capture.

New awards totaled $34.8 billion.

We're especially encouraged by several trends we saw in 2007.

First, our technology continues to be a competitive discriminator.

We saw this in both our core markets as well as in adjacent markets and with new and nontraditional customers.

We won competitions for Navy UCAS, GPS operational control system, ground air task oriented radar, called GATOR, and the Crew 3 counter IED contract.

We were awarded a U.S.

Postal Service contract to further automate mail handling, and we were also selected to outfit Marine Corps CH53E helicopters with our DIRCM missile defense system.

DIRCM technology also advanced in the commercial arena where testing is now underway on Fed Ex aircraft.

Secondly, during the year we were also awarded several contracts that marked the beginning of what promises to be a very long set of production runs for programs like the E2D advanced Hawkeye and the F-35 joint strike fighter.

These are both franchised programs that should provide profitable revenue for decades.

We were also awarded funding for the next lot of Global Hawk and large contracts for construction of the LHA 6 big deck and a ninth LPD assault ship.

And early this year we received the next increment of design and advanced construction funding for the first Gerald Ford class aircraft carrier, CVN 78.

We also saw an upturn in international business that was very encouraging.

Examples here are the Euro Hawk award and the Mesa radar for Korea.

Electronics where most of our international business resides had record acquisitions in 2007 of which approximately 25% is international and foreign military sales.

In additional to traditional international sales of electronics, we are also seeing substantial international opportunities for security and infrastructure protection such as the United Kingdom's IDENT 1 program.

Lastly, we've been very successful across the Corporation in winning competitions in the intelligence and restricted arenas.

We continue to pursue tens of billions of dollars of competitive new business opportunities.

We've discussed many of these upside opportunities with you in the past such as the Air Force aerial refueling tanker and the BAMs.

But two important new opportunities I would like to mention today are the Army's aerial common sensor restart and the Army Marine Corps joint light tactical vehicles program which we're doing in partnership with Oshkosh Truck.

On JLTV Northrop Grumman brings rich experience in the design, development, and systems integration of complex mission equipment on military platforms.

Our partner Oshkosh Truck brings unparalleled ability in advanced extreme duty vehicle systems.

This combination will enable our team to deliver the best JLTV solution to our nation's war fighters.

In summary, 2007 was a very good year for Northrop Grumman and for our shareholders.

We captured business in new and adjacent markets, grew sales, improved performance, executed our balanced cash deployment strategy, and announced several organizational realignments designed to position the Company for the future.

We also announced some changes in our senior management.

Scott Seymour and Jerry Agee will be retiring from Northrop Grumman this year.

Gary Irvine will head integrated systems and Phil Teel will be taking the helm at mission systems.

I want to thank both Scott and Jerry for their contributions to Northrop Grumman over the years.

I also want to acknowledge the outstanding job Phil Teel did in leading ship systems and his work on the recovery from hurricane Katrina.

Ship building is moving in the right direction.

Mike Petters will now take over as we combine Newport News and ship systems into one business which we will call ship building.

Our rich bench of leadership talent will enable a seemless transition into this new structure across the Company.

You will meet these terrific executives in their new roles at our upcoming investor conference on February 26.

In looking at the year, we're pleased with our progress, and we will continue to focus on improving opportunities going forward.

We continue to be keenly focused on growing our sales, expanding margins, increasing EPS, and further improving cash performance.

Looking ahead, we expect the positive trends of the just-concluded year to continue in 2008.

Our $64 billion backlog gives us a solid base for growth.

In 2008 we expect sales of approximately $33 billion, earnings per share of between $5.50 $5.75 a share with cash from operations of 2.8 billion to $3.1 billion, and free cash flow of 1.9 billion to $2.3 billion.

We had a terrific year in 2007, and 2008 is shaping up to be even better.

Now I would like to turn the call over to Wes Bush for additional discussion on Northrop Grumman's operations.

Wes.

Thanks, Ron.

Hello, everyone.

My comments are outlined on slide four.

From an operational perspective 2007 was a year of solid improvement in programs, performance, and significant risk reduction.

From a risk reduction perspective, several challenging programs have shown marked improvement and good progress towards completion.

For example, we completed the restructure of the in-post contract and all pre-Katrina contracts and ships which represent several billion dollars of our contract base.

We also settled two legal matters with Cogent and Goodrich.

We successfully completed critical scheduled milestones on block 60 with all hardware delivered and performing well in country.

We're continuing to make good progress on the Falcon Edge software and we expect to retire that technical risk over the course of this year.

On Wedgetail we're also making good progress.

We're currently completing the development phase and expect to transition into type acceptance testing later this quarter or early next quarter.

The technical risk is retired with the culmination of that testing, presently anticipated in the third quarter.

Lastly, on LHD8 we're continuing to make progress towards our scheduled year end delivery date.

I also want to provide a little more background on our recently announced organizational changes.

Our primary goals and realignments, our enhanced support to our customers, better utilization of capabilities and resources, and of course operating improvements.

Our customers including the Navy have expressed their strong support for these realignments.

The combination of our Gulf Coast operations with Newport News will further enhance our world class ship-building enterprise and provide an integrated interface and full range of capability to say our customers.

We'll be able to more efficiently utilize our assets, deploy our ship builders, and invest for the future to meet our customer's needs.

We do not anticipate any facility closures or significant reductions in yard employment levels as a result of this realignment.

In fact, we continue to be in a hiring mode in many of our ship building locations.

We do expect cost savings to result from a realignment over time.

We also announced that our missiles business with approximately $900 million in revenue will now report as a part of space technology.

This business comprises our ICBM and KEI programs as well as our missle engineering center and is an excellent fit with our space technologies customers and its advanced technology profile.

This transfer will enhance our Company's overall support to our Air Force and our Missile Defense customers and it will optimized our capabilities and resources.

Mission systems focus will be on our rapidly growing C4 ISR business.

Now this change will be effective July 1, so you won't see it reflected in our financials until we report our third quarter results later in October.

We're also focused on improving our performance by strengthening program management oversight and processes, increasing our discipline around bid and contract negotiations with strengthened threshold criteria, and of course driving cost competitiveness through process improvements.

A good example of this is our recently established enterprise shared services organization whose charter is to deliver high quality enterprise wide services to our sectors at very competitive costs.

These efforts will produce continuing improvements throughout the Company.

With that, I will turn the call over to Jim for a more detailed discussion of our financials.

Thanks, Wes, and good afternoon, ladies and gentlemen.

My comments begin on slide five, and they will summarize fourth quarter and 2007 results as well as 2008 guidance.

The highlights for the quarter and for the year were sales growth, margin expansion, both in dollars and in rate, earnings per share growth, and record cash performance.

As a result of our very strong performance we exceeded our guidance for sales, EPS, cash from operations, and free cash flow.

For 2007 we have improved by every measure.

Sales were up 6%.

Segment operating margin is up 40 basis points to 9.7%, total operating margin rate is up 120 basis points to 9.4%.

Cash from operations reached a record $2.9 billion even after the $200 million discretionary pre funding of our pension plans in the fourth quarter.

Free cash flow topped $2 billion, a record for the Company, and an impressive 116% conversion of net income.

Now moving to slide six, the businesses combined for a 10% increase in sales for the quarter and a 6% increase for the year.

All four businesses posted higher fourth quarter sales.

Information and services rose 11%, ships increased 19%, and electronics rose 8.

For the year information and services is up 11%, ships is up 9, and electronics is up 6.

These increases were more than offset by the -- or these increases more than offset the 3% year-over-year sales decline for aerospace.

The trends driving the fourth quarter and full year sales are consistent with the results for the first three quarters.

For information and services, the drivers are the large state and local programs we won in 2006, the Essex acquisition, new program wins and additional revenue from existing intelligence programs, and the Nevada Test Site program.

We had small increase in aerospace this quarter due to higher volume for restricted and civil space programs.

This was more than offset by the expected downturn in integrated systems revenue as large programs like the E2D advanced Hawkeye, the F-35 and the EA-18 Growler transition from development to production.

Our electronics business continues to see strong demand for electro-optical and infrared countermeasure products including the inaugural DIRCM contract with the Marines.

Electronics is also seeing growth in communications and ISR along with additional volume for restricted business.

Higher sales for ships reflects the recovery from hurricane Katrina, ramp up on LPD and LHA programs, the inclusion of revenue from AMSEC, and higher volume for Coastguard, aircraft carrier, and submarine programs.

Moving onto slide 7, segment operating margin rose 15% for the quarter and 11% for the year, and for both periods margin rate expanded by 40 basis points.

All four businesses posted double-digit operating margin increases in the fourth quarter, and for the year operating margin is up 37% for ships, 8% for electronics, 7% for aerospace, and 3% for information services.

Looking at the fourth quarter and full year trends, aerospace, electronics, and ships operating margin rates are generally in line with what we discussed as our fourth quarter expectations and our last quarterly earnings call.

Aerospace fourth quarter operating margin is 100 basis points higher than the fourth quarter 2006 at 9.7%.

For the year aerospace operating margin rate expanded 90 basis points to 10.4%.

These increases are primarily driven by improved results at integrated systems.

Electronics margin rate for the fourth quarter expanded 85 basis points to 12.1% and for the year expanded 25 basis points.

For the year information and services came in at 8%, in line with guidance but the fourth quarter operating margin and rate are lower than I expected.

Information technology fourth quarter margin and margin rate reflect a higher percentage of lower margin state and local business.

In addition, IT's fourth quarter margins were also negatively affected by about 120 basis points due to final allocation of state income taxes among the sectors and year end cost accruals.

Without those items, IT's fourth quarter performance would have been in line with expectations.

For the Company we expanded total operating margin rate by 80 basis points for the quarter and 120 basis points for the year.

Total operating margin increased $137 million or 22% for the quarter and $542 million also 22% for the year.

The improvements for the quarter and year-to-date are due to better performance by all four businesses and lower net pension expense.

Results for the year also include lower unallocated Corporate expenses primarily legal provisions.

Our effective tax rate in the fourth quarter was 34.6% compared with 33.6% in last year's fourth quarter.

For the year our effective tax rate is 32.9% versus 31.2% in 2006.

Slide 8 provides a revised format for our reconciliation of net income to cash from operations and free cash flow for the quarter and year-to-date.

This new format summarizes noncash items like depreciation and amortization, stock-based compensation and deferred taxes into a single line and highlights trade working capital.

For the fourth quarter including the $200 million discretionary pension prefunding, cash from operations was $734 million.

Capital spending was slightly higher than last year, bringing us to free cash flow of $432 million for the quarter.

For the year the major items driving the strong cash performance are higher net income and noncash items, reduced pension funding and improved trade working capital.

We've been very focused on working capital improvements which is reflected in our 2007 results.

For the year we reduced trade working capital by $142 million despite a $1.9 billion increase in sales.

Capital spending for the year totaled $685 million and outsourcing contract and software related costs are $137 million bringing us to free cash flow of $2.1 billion, an improvement of $1.1 billion over 2006 and 116% conversion on net income.

Now let's move onto 2008 guidance.

Actuals for 2007 and our guidance for 2008 are depicted on slide 9, but I want to provide some perspective on how I view the fundamental trends year-over-year.

We expect 2008 sales of about $33 billion or slightly more than a 3% growth.

This estimate is for organic growth only and we could see some upside to this number depending on timing and funding profiles for several new competitive programs which are scheduled to be awarded this year.

Segment operating margin rate is expected to be in the mid-to high 9% range compared with 9.7% in 2007.

In comparing to 2007, keep in mind that our 2007 rate included a net positive impact of approximately 20 basis points for items such as the Katrina insurance recovery, AMSEC gain, and completion of contract negotiations with customers offset somewhat by a negative earnings adjustment on LHD8 in the second quarter.

So adjusting for the the impact of these special items, 2008 does call for continued performance improvements and margin rate expansion from our operations.

Operating margins should improve to high 9% range as a result of lower pension expense and somewhat lower corporate unallocated expenses.

For EPS we expect a range of $5.50 to $5.75.

With 7 to 11% improvement over 2007, reported results will be driven by higher sales and higher operating margin.

The EPS range assumes an effective tax rate of about 34% and a 2% reduction from 2007 weighted average shares outstanding through open market share repurchases.

Turning to cash, for 2008 we expect cash from operations to be in the range of 2.8 billion to $3.1 billion which reflects growth generally in line with that of net income.

Free cash flow is projected to range between 1.9 billion to $2.3 billion which should translate again to a net income conversion of 100% or better.

We'll be providing more detail on trends we expect in our business segments at our investor conference on February 26.

In summary, it was a very strong quarter, and we crossed the finish line with record results and a solid foundation going into 2008.

Gaston, with that I am ready to turn the call back over for you for Q&A.

Thanks, Jim, we're ready for questions now and ladies and gentlemen before we start we'd ask that you would limit yourself to one question as we work our way through the queue.

(OPERATOR INSTRUCTIONS) Your first question is from the line of Robert Spingarn with Credit Suisse.

Good afternoon, everyone.

Hi, Robert.

Jim, could you give us a little bit more color on your '08 guidance on the segment level?

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

Yes.

And you're looking for sales growth or margins or?

Sales, margins, just directional commented tear to the extent you can offer that above and beyond what you've got here on slide nine.

Sure.

Let me walk through the both sales and margin rates as I see them.

I do see sales growth essentially in information and services, aerospace, and electronics systems, ships revenues, I think are fairly constant year-over-year.

In terms of margin rates, I expect information and services to kind of be in the low 9% range, aerospace ought to be in the mid-9% or so.

Electronics 12, 12 plus type range, and I think ships will be in the low 9% range.

Okay.

Then on your free cash the mid-point of your guidance there implies a slight erosion in what was exceptional performance this year.

I know you said 100% or better, but you were at 1.2.

Could you talk about what needs to happen to maintain that 1.2?

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

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

Robert, I think the best way to describe it is we're at the very beginning of the year.

I think there are opportunities, but we, as I have mentioned in the past, we are driving on working capital.

We've made good progress.

We're not finished.

I think there are additional opportunities, and it is up to us to bring those home.

Thank you very much.

Thank you, Rob.

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

Jim, just to follow-up, what's your assumption for FAS CAS in 2008 over '07?

About $100 million improvement, Steve, in our net pension expense driven essentially by three items, our discount rate is going to move from 6 to 6.25.

We did have really good investment performance in the plants this year, above our 8.5% long-term rate of return assumption, where actual investment performance was a little bit above 11%, so very strong performance in a choppy market, and then thirdly the $200 million pension prefunding that we made in the fourth quarter also has a positive impact on that change and pension costs year-over-year.

Okay.

Then in the -- space technology had one of the best sales increases we've seen in a long, long, long time, in fact for many years, I am not even sure when was the last time that was repeated, and you noted that restricted activity picking up in the quarter, is that a trend that we should see sustained in 2008, and I am not talking about 14% growth, but is the growth in classified activity going to continue in '08 and can we see stronger growth out of space technology?

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

Thanks a lot.

Your next question comes from the line of Cai von Rumohr with Cowen & Co.

Yes, general corporate and unallocated, $224 million.

How big was the check you wrote to Goodrich in the fourth quarter and where, you said it is only down slightly, but you had a couple of large abnormal negatives in '07.

I would think it would be down toward the 140 level.

Is that being too aggressive, and if so, why?

You're partly right, Cai.

We did write the check and settle with Goodrich late in the fourth quarter, frankly from a quarterly impact it was insignificant.

The bigger driver in corporate unallocated for the year is essentially the second quarter provision we made for a number of various legal items.

There were some adjustments of legal items in the fourth quarter as well, but it was by far not nearly the size of the second quarter adjustment.

In terms of corporate unallocated going forward, I kind of look for about a $25 million or so decrease over the 2007 level.

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

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

Great.

Thanks so much.

Okay.

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

Good afternoon.

Hi, David.

Good morning.

You talked about shifts, Jim, flat in 2008.

Can you just give a little bit more color around that?

Obviously you had the strike impact in '07.

You were still operating running at a pretty low rate in the first and second quarters.

I am just a little surprised you wouldn't see a little bit of growth in that business in '08.

Well, I essentially see a little bit of growth, but I don't know that it is enough to -- it is not the 4% number that I talked about for information and, for example, for information and services, so there is a little bit of growth, but it is not a whole lot.

David, this is Ron.

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

And a follow-up, Ron, can you maybe talk about long-term what you see for the ship building business, your partner on Virginia class submarine laid out a pretty strong growth profile over the next couple of years partially driven by a second sub a year, so just thinking about a little bit longer term what you see for the business?

Well, we see a solid business going forward.

We believe that the Navy will move to two Virginia class per year in 2011, and probably that gives us some work ahead of time.

As you know, we are partnered with Joe Dynamics, we are their subcontractor.

While we split the work, our revenue is only that piece which we have.

We also see the DDX program picking up.

We'll also have some tailing off of the DDG-51 destroyer line which has been a tremendous line for us in the next couple of years.

We do see a steady production of aircraft carriers going forward, and in fact the Navy has put a couple of carriers in their palm.

I believe they're on four-year centers, and this is of course the Gerald Ford class, the new CVN 78 class.

So I think overall I think we see a solid business and to echo Jim, I don't think we see a dramatic up spike in revenues, but we do see a solid business, and I think the story in ships is driving the performance levels both in terms of margins and cash year-over-year better in the next couple of years.

Thanks a lot.

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

I am interested in the realignment in ship building and I know really for the last three years you'br talked a lot about taking lessons learned from Newport News and using those in the Gulf shipyards.

What's led you to the decision to do this realignment now?

And what levers do you expect to use to improve performance there?

Well, Doug, this is something we have considered since we made the acquisition of Newport News quite a number of years ago.

The difficulty was that initially Newport News had some issues in terms of delivering carriers and what have you, and then unfortunately as we got to the place where we were in good shape there, we had Katrina hit us which really was a devastating impact a couple of years ago.

We felt that managerially we would be much better off to focus on the two businesses with two very powerful executives running those businesses, collaborating but running those businesses in parallel.

We're now at a position where from a performance standpoint and a recovery regeneration standpoint in the Gulf we can and we have announced the unification businesses in terms of a single sector management team.

We have in fact increasingly been working on moving best practices capabilities both ways by the way, not just from Newport to ships but also the other way around.

We think that putting a common management in place we'll be able to accelerated that, but more importantly we will be able to probably more agilely operate in terms of managing workflow peaks and valleys in each of those yards.

It turns out as you look forward in '08, '09, '010, you do see some variations in manpower requirements in those yards and manpower is actually crucial because they're the skilled people that we need to build ships.

In some cases we have a demand for manpower in one of yards and we have a shortfall of work in the other, so we have the opportunity to probably more agilely move the work back and forth as we need to.

As Wes indicated, we do plan to continue hiring.

We have some strength going forward in both areas, and so we just think that we're going to have a more efficient operation operation overall.

I would also finally mention that it simplifies our interface with the Navy at the highest levels because now we have a single executive in charge of the ship building business.

As part of this, one of the things that I understood post Katrina that you wanted to do in the Gulf was to introduce quite a bit more automation and in fact use the Katrina situation in a way as a catalyst to start with a clean sheet of paper and do things somewhat differently.

Assuming that's the case, can you comment on how things have progressed in terms of automating things more and also will this realignment help in that?

Yes.

Doug, we've made substantial progress there.

Let me ask Wes to give you a couple more pieces of color on that.

If you look at what we've done in the Gulf since Katrina, we did use it as an opportunity to retool our operations there, redefine the process for the workflow, we've redefined the way in which the work actually gets done, introduce new technologies such as wireless technology into the shipyard to help facilitate the flow of inventory and the application of labor in a more efficient way.

There are a lot of things that we have taken on that are going extremely well, and I give the team and the Gulf an enormous amount of credit for not only recovering from Katrina but figuring out how to use it as that opportunity to step ahead.

As Ron indicated we have an opportunity to bring a lot of best practices from Newport News to the Gulf, and we have a lot of opportunity to bring not only longer term best practices but some more current more recent ways managing the workflow to Newport News.

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

Thank you.

Your next question is from the line of Joe Nadol with JPMorgan.

Thanks.

Good morning.

Good morning, Joe.

I would like to ask you about the state and local part of your IT business.

I am wondering, I guess first of all what's the contract structure generally on those programs?

Is it fixed price, or is it time and materials, et cetera?

And is this intrinsically a lower margin business or are these big long-term contracts where you're initially taking a more conservative booking rate and seeing how things go?

Maybe just help out a little bit with that?

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

Could you characterize for the fixed price portions of -- or the the fixed price contract specifically, is there sort of a risk reduction as you go in and see what has to get done?

And is that, A, a risk, and B, is that a potential reward as you hit those milestones you're able to increase the accrual rates?

All of that would be true.

Essentially with long-term contracts and in particular IT long-term contracts there is always changes that occur whether it is in hardware or software or applications.

All of those are central opportunities for further revenue growth and margin opportunity.

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

Essentially we transition to San Diego at the end of the year, and we will finish transitioning Vida mid-year of '08.

Okay.

Thank you.

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

Good morning.

Ron, can you talk to us about -- help us better understand DoD's newly announced policy of requesting multiple prototypes on major acquisition programs?

How does that affect Northrop's business going forward?

Well, Heidi, first of all, I think it is an interesting policy.

It is probably a very good policy, Secretary Young has obviously put that in place.

The challenge is that you need a little more up front money to carry three guys instead of two.

On the other hand, these are very very big weapon system decisions they have 30, 40-year life cycles, so it is important to get them right at the beginning.

We think this is great.

Obviously it gives us an opportunity to participate and show what we can do, and we would much rather win a program as a result of having the best offering as opposed to maybe writing the prettiest proposal.

One example I can give you is is the joint light tactical vehicle program which we did just recently announce our participation with Oshkosh.

That's a huge program.

That could be a $50 billion program over the next several decades.

It will replace all the Humvees in the inventory.

We think that the opportunity to demonstrate what we can do through a prototype period is an excellent idea, and by the way, the contractors will learn from the government what they really want, and the government will have a much better understanding of what it really needs to buy as it clarifies its sense of requirements and has the benefit of competition.

I think that's a good idea, and there will be other examples of that going forward, and obviously as a contractor we'll be nimble, we'll participate as the government wants us to.

Do you see concern about this being a funded on the contractors coin initially or does it look like they're prepared to fund those?

I think in general, Heidi, these will be funded by the government.

Of course there will be the opportunity for the Company to invest some research money if appropriate.

I don't think we're back to the days, if you remember back in the old airplane competitions with the A-12 and others where companies were basically betting themselves -- betting the farm on whether or not they would win the program.

I don't think we're going to see that.

I think certainly the industry would find that fairly unappealing, and those of us running these companies will obviously have to make our own decisions, but I think we're looking at a case of generally funded prototypes.

All right.

Lastly, you talked a lot about the efficiencies that you're making in the Gulf and obviously it looks like the procurement of bow wave and ship building is finally on us.

When, when you look going forward, when do you think you can get to 10% margins in ships?

I think over the next two years.

Obviously we have to work our way through the inventory of ships that are already under contract.

We're working through what we euphemistically call the pig and the snake in terms of the Katrina affected ships, and we're working those through the system.

I would say in a few years we should be able to move in that direction, and we are absolutely focused on moving the efficiency and the profitability of this business to a place where we think it should be, where we know you think it should be, and if you take a look at the progress we've made to date in the last few years despite the impacts of Katrina, despite the impacts of the strike, I think you can see we've got a heck of a trend going.

Great.

Thanks very much.

Thanks, Heidi.

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

Good morning.

I would like to stay with ships if I can.

I have sort of two things that I don't understand.

Nick [Chubraya] is talking about his ship building business sort of being -- catching about 500 million less than you and catching up to you this year and growing 40% over the next three years that follow.

So I am trying to understand whether there is a shift in the mix between the nation's two ship building programs where Judy is winning and you guys are losing or whether you're just being more reticent about what you see going on.

The second aspect of the ship building thing that I don't quite understand and maybe you can help me with is just the sort of traditionally Newport News is an all-cost plus, known as a very expensive shipyard that builds very complicated nuclear power ships and the Pascagoula Yards have been known as people that build fixed-price ships and always having to compete, and I just sort of don't understand how after all these years it will make sense to have the guy that normally is not that attentive to costs run the shipyard that needs to be attentive to costs?

Well, Joe, you've asked a number of questions and made a number of assertions.

Let me take them one at a time.

First of all, I really can't speak to Nick's Chubraya's forecast for ship building.

You have to ask him about that.

I am not aware of winning or losing.

We're both building DDXs together in partnership.

We're both going to be building Virginia classes together in partnership.

We have significant work coming in aircraft carriers.

We have significant work in amphibious assault ships including the LPD line and the LHA6 newly awarded.

We're not participating in LCS, and we're not participating in bulk carriers such as TAKEs, we're not participating in oil tankers or crew carriers and that sort of thing.

So to that extent there might be some difference in the mix.

The things that I am aware of we certainly know our plan going forward, it is a matter of public record with the Navy.

We're obviously partnered with GD on subs.

We work together on those.

I am not aware of GD winning and Northrop losing.

In fact, quite frankly, we find ourselves cooperating across the board on almost everything now as directed by the Navy.

That's going very well.

With respect to your--.

Ron, does that mean that we should expect very strong growth in ships?

Nick said this is the strongest part of the entire GD portfolio.

I think that's great, and I am not predicting that at Northrop.

What we're telling you is that we see steady revenues in ships based upon the mix we have.

Great.

Thanks.

Okay.

Near term.

Long-term, who knows long-term.

With respect to your other comment, first of all, let me point out that a substantial portion of Newport News' work is fixed price.

In fact, by dollar volume of the $3 billion or so they do there, the overall majority of it is fixed price in some form, fixed price incentive, as we move into the submarine work it is fixed price, the carrier production work is fixed price.

They're extraordinarily attentive to costs at Newport News, and Mike Petters, the executive who runs Newport News has been extraordinarily focused on efficiency and costs because in fact, it makes a significant difference to the profit of this Company how he rf performs.

The ability of both yards to work together and share best practices is very, very important.

Yes, there are somewhat different cost structures in both yards.

For example, the Newport News yard does need to maintain some cost structure additions to provide nuclear safety issues that we don't deal with in the Gulf.

We've streamlined the Gulf for that years and years ago, probably 30 years ago the Gulf also did some nuclear work, it does not do that today.

We have different cost structures in different parts of the business, but fundamentally we are driven by costs and better cost performance results in profit.

So I think what you're going to see is continued attentiveness in that regard.

This is Jim, I would just point out or echo what Ron had said.

In some ways cost-type contracts are as the customer is as concerned about costs as anyone else is.

With the margin rate emphasis that we've had, over running a contract to increase sales declines the margin rate which is not what we're after, so I can assure you that we are after delivering our cost commitments to our customer, to all of ourselves that we have used for our planning purposes, so the emphasis is on, equally on costs, whether it is at Newport News or at Pascagoula.

It just struck me given all the years of two Navies, the nuke Navy and the rest of the Navy that you start announcing it as one customer.

Well, I think this is the future, and I think what we're seeing is interrelationships.

If you think about it, when you have to fund an aircraft carrier, it takes a significant amount of total obligational authority away from other ships, and when you don't fund an aircraft carrier, you can fund other ships, the natural effect of that rippling through the industrial base is the movement of work, and we think that over time it is better to be able to deal with this in an integrated way, and we can basically share work and not have to rapidly hire and rapidly lay off highly skilled workers.

We found that over time steady industrial bases in both those shipyards is a much more efficient way to go.

It is win-win for the government and it is win-win for us.

And in fact, this is Wes, in fact, I made the quick comment in my remarks earlier.

The Navy has been very supportive of this, specifically for that reason, that you're right, historically there had been a little bit more of a -- of narrowly defined missions, and budgets that flowed with that, and perhaps not as much cross overeffect within the Navy itself.

The Navy is looking to the future.

They're taking actions to think about their portfolio and a more integrated aggregated sense, and they see this step in our part as very aligned with where they need to go as well.

It works well together for us and for the customer.

Thanks.

That's very helpful.

Appreciate it.

Thanks, Joe.

Your next question comes from the line of Robert Ballard with Banc of America.

Good afternoon.

Hi.

Ron, just a structural question.

You highlighted how much your operating margins have improved since 2003.

Do you think you're now as a Company reaching the the point where the operating margin is like to slow down in terms of its upward progress?

Robert, clearly we've had a dramatic improvement in the last four or five years.

You're not going to see that going forward, but we are going to see some improvement but at a slower rate.

Okay.

As a follow-up looking to the longer term as well, what's your thoughts on the trajectory of the U.S.

defense budget looking at both the core budget and the supplemental?

I think every year this time there is a lot of concern that the defense budget is either peaked or is going to be reduced substantially.

We do not see that, Robert.

We certainly see an '08 budget which is substantially stronger than the '07 budget.

The Northrop programs and interests are very well provided for.

Based upon our early understanding of the '09 budget process and as you know that's just still underway in the Pentagon and has not yet been presented to the Hill, every indication we have is that there will be a continued growth of reasonable proportions in the basic budget.

This is quite separate from the supplementals, but the very basic budget we expect is going to grow as well in terms of procurement and RDT&E.

As far as the supplemental is concerned, that's a different situation.

That's going to be debated by Congress here in the spring.

There is going to be need for supplementals, obviously the handle, the war, the operational issues and also, frankly, some additional procurement and replenishment.

Where we go with those after the next administration comes in, whether those are handled separately or whether they're part of the initial submittal, I do not know.

One thing I will tell you though is that this Corporation is reasonably resistant to a significant reduction in supplementals or a more rapid withdrawal from Iraq than maybe some other companies.

We're not participating and have not in the last several years in much of the supplemental money.

The basic money in terms of the basic budget for a procurement RDT&E we see that continuing to be strong in '09 and probably into '010.

That's great.

Thanks, Ron.

Thanks.

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

Good morning.

Good morning, George.

Just a couple of questions.

The ship revenues were a lot higher in the quarter than what you've been forecasting for the year.

Since that seems like a fairly predictable thing to me, I was just wondering kind of what happened in the quarter that you hadn't captured it in your guidance before?

Ship's revenue for the year essentially are right on our guidance at the very beginning of the year.

George--.

You weren't guiding for this much of an increase this Q4 relative to where we were in Q3, so I was just wondering?

George, we haven't -- we've only given annual guidance, and we had a range for ships, and the actuals came right in the middle essentially of that range.

And then just in general, Jim, if you take a look at your guidance, you're getting 2% benefit in earnings from share reduction which is about $0.10.

You're getting another $0.19 benefit from the $100 million increase in pension.

Granted that during the year you had some legal issues and you had some benefits, it wouldn't seem just with those two items by itself you get up to 540 or so, so it wouldn't seem just off the top of my head that you're projecting a big increase in the operating earnings out there, and I am just wondering whether you're just being overly conservative or there is some major things that I am missing?

George, as I think about the guidance going forward, essentially there are upsides or uppers from '06 -- I am sorry, '07, for pension for additional volume, tax rate is a negative, earnings per share or weighted shares outstanding is a positive, and then there are operational improvements that go into it as well.

Those are the four items that essentially move from '07 to '08.

Okay.

Thanks.

Your next comes from the line of Ron Epstein with Merrill Lynch.

Good afternoon, guys.

Hi.

Ron, could you walk through maybe in a little bit more detail you did some on your introductory remarks, some of the upcoming programs that you're keeping your eye on?

Sure.

Obviously the big news items are involving tankers where we think that the current plan is to go to a Defense Acquisition Board meeting we've been told the 13th, of February which will be a review with the under Secretary of Defense, and then following that shortly thereafter we're told that there will be an announcement of a decision, winner take all.

That same DAB date is the date for the BAMs program which is a unmanned reconnaissance program for the Navy, so that one we have in the mill.

Both those we have our final proposals in on as do the competitors.

I did mention the aerial common sensor restart.

As you recall a couple years ago, there was a competition.

We were unsuccessful in that competition.

However, within less than a year after the program was initiated, it was canceled.

There was a reconsideration of how to proceed.

Two things happened from that.

One is a substantial amount of near term money came to us to upgrade the guardrail program of which we are the incumbent, and secondly a decision to restart the aerial common sensor competition, and we see that competition opening up this year and probably get an RFP sometime later in the year and perhaps a down select in '09.

We have proposals in on PSAT.

We're teamed with Lockheed.

That's a very very large job for us.

We're providing the payload for the satellite, and that's a big portion of the job with our partner Lockheed.

The JLTV as we've said we've announced our intention to participate there, and we were selected as one of two in a down select on the GPS ground station work, and we will be in a process over the next year or so of proceeding to build prototypes in parallel with our competitor and then it will be a down select probably about a year from now on that one.

There are probably about another 5,000 or 6,000 other programs that we're probably in the process of bidding, preparing updates for, that will happen as well, but those are a few that I think maybe catch the headlines.

Okay.

Great.

Then if I could follow-up, with just maybe just a smaller accounting question.

On the quarter, if you take out some of the smaller M&A that you did, what was the organic growth for the Company top line?

For the quarter?

Yes.

Ron, I guess it is easier for me to answer it for the year.

I think you take out the acquisitions and we're kind of in the 5% range organic growth.

Okay.

Okay.

Great.

Thanks.

Yes.

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

Thank you very much.

Two questions.

One to go back to electronics, very nice showing for the year and nice to see, it looks like you're getting some of the risk programs under your belt.

Could you elaborate a little bit more on where you are in terms of the MESA Radar and some of the other items?

Yes, Howard, it is Wes.

Let me take you through that a little bit.

On both programs, just to give you the headline summary, on both programs we're continuing to make good progress, and we're continuing to perform within our established EACs, so we're very, very pleased with how that's going.

You asked specifically about the MESA programs.

We are finishing off the development test and evaluation phase.

We have some software upgrades that are underway as well as, as I mentioned at the end of the third quarter we're continuing to focus on getting the electromagnetic interference testing done this quarter, the first quarter of this year.

We do expect to get into the type acceptance testing later this quarter or early next quarter in that kind of range of time span, and as we think about retiring the risk over this program, we're really looking to that type acceptance test, set of activities, to get that risk retired by the third quarter of this year.

So good progress.

We're pleased with what the teams are doing there.

There is always challenges and risks on these leading edge programs.

But if you look back to where we were this time last year, we've made tremendous progress on both Block 60 and on MESA.

And so I didn't hear -- you talk about the $40 million exposures.

Will I just find it in the Q or do you feel more comfortable that that's going away?

There has really been no change with respect to our perspective on that, so the disclosure that we had in the Q continues to to be our position on that.

Just a larger macro question for Ron and if you look at your outlook, it is kind of a 3 percentage sort of growth number.

While I recognize cash is more important than revenues, the budget overall is growing at we'll call it high single digits, and so you're lagging a little bit.

I know some of it is always mix, but is there any incentive for you or does the Board ask you to step up the pace?

Of course.

We're trying to step up the pace wherever it makes sense.

We also want to take on good contracts, too.

We're not just driving ourselves to the top line.

I am not sure about the high single digits.

Maybe that is a different budget than I am aware of.

Certainly what we're involved in we've given you our best guidance for it.

Next year, we've not given you a longer range forecast, and remember the budget for next year with the government will be a planned set of commitments which will play out over the following years after that.

We're certainly trying to drive the needle up as fast as we can, but we're much more concerned about cash, earnings per share, quality of earnings, than just pure top line.

We could obviously go get top line easily any time and take on bad contracts, but I think that's not something that we're about doing.

Okay.

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

Thank you for your participation in today's conference.

This concludes the presentation, and you may now disconnect.

Good day.