諾斯洛普·格拉曼 (NOC) 2008 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 Katina and I will be your coordinator for today.

(OPERATOR INSTRUCTIONS) I would you in like to turn the presentation over to our host for today's call, Mr.

Gaston Kent, Vice President of Investor Relations.

Sir, please proceed.

Thanks, Katina, and good morning, everyone.

Welcome to Northrop Grumman's second quarter 2008 conference call.

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

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

Before we start, please understand that as shown on Slide Two, some of the matters discussed on this call 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 the 10-Q which was filed this morning.

We're also filing a shelf registration statement with the SEC that replaces the Company's existing shelf registration, which would have expired later this year.

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

During today's call, we will also discuss the outlook for the remainder of 2008.

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

We also want to draw your attention to schedule 6 of our earnings release.

This schedule provides 2006 and 2007 reported and realigned results that reflect the transfer of certain missile systems programs from mission systems to space technology.

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

We would now turn to Slide Three at this time, I would like to turn the call over to Ron.

Thank you, Gaston, and hello, everyone.

Thanks for joining us.

We're pleased with second quarter results, particularly with the nearly double-digit sales growth we posted this quarter.

All four of our businesses generated higher sales led by ship building and aerospace.

Fully diluted earnings per share increased 10% and EPS from continuing operations increased by 4% with a difference being the gain on the sale of our Electro-Optical Systems business that's reflected in discontinued operations.

Both of these increases come on top of last year's $0.05 per share tax benefit.

Second quarter operating income and margin rates are healthy and at the midyear point, we are on track to meet our 2008 guidance.

Cash from operations and free cash flow are improving, as we move through the year and are on track to achieve the guidance.

As you know, our cash generation typically increases as we move through the year and we expect cash to be very strong in the third and fourth quarters.

We continue to execute our balanced cash deployment strategy during the quarter, repurchasing approximately 2.8 million shares of our stock.

Year to date, we have repurchased 10.3 million shares for approximately $800 million.

There is $1.7 billion remaining on our current repurchase authorization.

We ended the quarter with a total backlog of nearly $67 billion.

New business awards in the quarter totaled 7.5 billion and include new competitive awards, as well as follow-ons to some of our franchise programs.

This brings year to date new business awards to approximately $20 billion.

We won the Navy's $1.2 billion Broad Area Maritime Surveillance, or BAMS contract in the second quarter, another strategic victory for Northrop Grumman.

As with our tanker win, one of the losing bidders has protested the award.

We expect the GAO decision on BAMS protest by mid-August.

Other important wins in the during quarter the include a significant position on JTRS, the Joint Tactical Radio System AMF; STARLite, a US Army contract to produce the new multifunction radar, or its ERMP Unmanned Aerial Vehicle program, as well as several important restricted awards.

And just last week, our technical services sector won two important awards.

First is participation in the contract field teams program, a seven-year indefinite quantity, indefinite delivery Air Force contract with a potential collective value of $10 billion.

Second is participation on the Air Force's flexible acquisition and sustainment tool, or FAST program, also an IDIQ contract that has a collective ceiling value of $6.9 billion over 10 years.

Another notable event in the quarter was the delivery of the first National Security Cutter, the Bertholf, to the United States Coast Guard.

This is the most technologically advanced ship in the US Coast Guard history and a potent new weapon to safeguard the security of our homeland.

Looking ahead, you are all aware that the Department of Defense will reopen the bidding for the aerial refueling tanker.

The government has said the rebid will be limited to a small number of procedural items identified by the GAO.

In announcing the Pentagon's decision, Secretary Gates reconfirmed that our Forces need the best tanker at the best value.

Our KC-45 is the most capable of giving the Air Force what it needs, better fuel efficiency, greater fuel offload and much lower risk.

That's why this tanker has won the last five global competitions against the 767.

The KC-45 tanker is built, tested and flying.

Its refueling system has completed more than 100 hours of in-flight testing.

New tankers are urgently needed now and our KC-45 is ready to go now.

The Air Force selected the right tanker in February and we are confident the Department of Defense will do so again.

The tanker is not the only significant new opportunity in our pipeline.

We are also competing for the Joint Light Tactical Vehicle, Aerial Common Sensor, the Transformational Satellite program TSAT, the GPS Next Generation Ground Control Segment, the Vehicular Intercommunications System's next generation, and other substantial opportunities.

I would like to comment for a moment on the Navy's recently reported plan to build just two DDG 1000 destroyers and then return to production of more DDG-51's.

This potential change to the Navy's ship building program will undergo review by the Secretary of Defense, as well as by both Houses of Congress.

As a partner with our customer, we will continue to provide the Navy with our input into how such plans impact the ship building industrial base, realizing that this is one of many important factors included in their decision-making process.

We are currently building one DDG 1000 and four DDG 51s at our Pascagoula shipyard.

We will support the United States Navy in the execution of the ship building plan they identify as best addressing the needs of our nation.

In summary, the quarter was solid.

It was another quarter in which we grew sales, generated solid returns, captured important competitive opportunities and maintained an outstanding backlog.

And for 2008, we are on a pace to achieve $33 billion in sales, $4.90 to $5.15 in earnings per share, cash from operations of $2.6 billion to $2.9 billion, and free cash flow of $1.7 billion to $2.1 billion.

All of which support our confidence in the outlook for Northrop Grumman in 2008 and beyond.

While today's call is focused on financial performance, I would like to take a moment to reflect on the recent dramatic rescue of our three coworkers, Thomas Howes, Marc Gonsalves and Keith Stansell, who had been held hostage for more than five years in Colombia by the FARC guerrilla forces.

I cannot overstate the joy we all feel to see them returned to their families and homeland.

I want to extend our heartfelt appreciation to the many men and women of the Colombian and United States governments who worked so hard for so many years to reunite Tom, Marc and Keith with their families.

While we celebrate their return, we are mindful that a fourth employee, Tom Janis, was killed by the FARC shortly after the plane crashed in the Colombian jungle in 2003.

He is deeply missed and will not be forgotten.

Now, at this point, I would like to turn the call over to Wes Bush.

Wes?

Thanks, Ron.

Hello, everyone.

My comments are outlined on Slide Four and will include updates on several programs.

I'll begin with Wedgetail.

As most of you know, the prime contractor announced a delivery delay and took a substantial charge on the program this quarter.

As a result of these delays, during the quarter we took an additional $20 million provision for the Wedgetail program, which contemplates the risk associated with this announced delay.

Our MESA radar for Wedgetail continues to make good progress towards completion.

We continue to improve the radar system stability performance and based on the prime contractors revised schedule, we expect to enter the type acceptance test and evaluation phase this quarter, with ground tests beginning in August and flight tests starting in September.

We also continue to support the prime contractor in the integration of the radar, with the mission computing systems, and radar performance continues to improve as the flight test program matures.

Regarding the F-16 Block 60 program, development acceptance testing has been completed for the Agile Beam Radar and the targeting system and we're on track to complete the next round of testing in the third quarter.

Final in-country development acceptance testing of these modules is scheduled for early in the fourth quarter of this year.

The Falcon Edge software for Block 60 continues to achieve intermediate delivery milestones toward its scheduled delivery in the second half of 2008.

The third and final increment of software has progressed from development to integration and will be delivered this quarter for flight testing and ultimate delivery to the customer for in-country flight testing and deployment.

There will be one subsequent software update completing the electronic warfare capability.

We continue to perform within our current EAC.

Moving on to our state and local programs, we're pleased with our progress and performance on both the Virginia outsourcing and the New York City wireless programs.

On Virginia outsourcing, we completed key milestones needed to transition to services delivery.

The cut over to services delivery occurred on July 1st as scheduled.

Ongoing infrastructure consolidation will continue into the middle of 2009 as scheduled under the contract.

The New York City wireless program achieved initial operating capability on March 31st.

We're continuing to build out the network and we anticipate full network capability later this year.

As this impressive capability nears completion, we expect to be adding new services in the future, further enhancing the utility of the network for the city.

On our county of San Diego program, we completed the transition phase last year and we're now in the recurring services phase.

A recently completed program assessment generated a reduced revenue projection for the remaining life of the program, and as a result, we've adjusted the value of the deferred cost to reflect this revised outlook, which negatively impacted second quarter performance.

Looking at our IT business model more broadly, we continue to grow and perform across the breadth of the marketplace.

We see substantial new opportunities for growth in all of our IT business areas.

Our information technology leadership team is taking significant actions aimed at improving operating and financial performance across the sector, including organizational changes, focused on reducing costs and improving organizational effectiveness.

One of these key actions has been to establish more stringent financial criteria for our business model in the IT outsourcing space.

I'll conclude my comments with the LHD 8 progress report as measured against the key milestones that we established last quarter.

The first milestone was the aft main engine light off, scheduled for the second quarter.

We successfully completed this milestone on schedule.

The next major milestone, scheduled for the third quarter, is completion of electrical cabling.

We've made significant progress in this area.

We have confidence that we'll meet this cabling milestone in the third quarter and I would add that timely accomplishment of this milestone is critical to our ability to support the test program on the delivery timeline that we've established.

We're meeting our schedules and we're on track to complete the remaining milestones, leading up to the delivery of LHD 8 in the second quarter of 2009.

Mike Petters and his ship building team are making tremendous progress on the program and Jim and I are personally reviewing LHD 8 progress on a weekly basis.

Now, my comments this quarter have again focused on a few challenging programs among the 20,000 in our portfolio that are demonstrating outstanding performance.

As today's results indicate, we're generating solid results across the Company.

Program execution is the fundamental driver of our performance and the improvements that we continue to demonstrate and performing on our current contracts, managing risk and capturing new business that generates value for our shareholders will enable us to meet our financial objectives.

Now I'll turn the call over to Jim to discuss the financials.

Thanks, Wes.

Good morning, ladies and gentlemen.

As both Wes and Ron indicated, we are on track to achieve our 2008 guidance and overall we're satisfied with the second quarter performance.

Growth for EPS from continuing operations for the quarter was 7.5% after adjusting for last year's $16 million, or $0.05 per share tax benefit.

We had strong organic sales growth, while at the same time maintaining the very robust backlog, and cash flow showed a marked improvement from the first quarter.

Although year to date cash flow is lower than last year, we have always expected a very strong second half for cash generation, as I said on last quarter's call.

Beginning with sales on Slide Five, all four of the businesses were up over last year.

The trends for information and services, aerospace, and electronics are consistent with the first quarter and demonstrate continued strength in product areas like intelligence, surveillance and reconnaissance for the information and services and programs like UCAS-D , EA-6B, Global Hawk, several key restricted and civil space projects for aerospace.

The 24% increase in ship building isn't directly comparable to last year, in that includes more than $150 million attributable to three events.

First is the impact of last year's Gulf Coast labor strike.

The second is the step down in sales resulting from the LHA -- LHD EAC adjustment last year and then the addition of AMSAC, which occurred in the third quarter of last year.

Adjusting for these three items, sales growth was more on the order of 13% in ship building.

This organic growth reflects a ramp up in activity for LPDs, DDGs and aircraft carriers.

Excluding these ship building items on a consolidated basis, the Company had high single-digit solid sales growth.

Now, moving to Slide Six, on a consolidated basis, segment operating margin declined by $14 million, and as a percent of sales, declined 100 basis points to 9.1% from 10.1%.

The majority of the decline in margin rate is attributable to three factors.

First is the decline at ship building due to the step down in booking rates on the Gulf Coast ship building programs that were impacted by the resource constraints caused by the previously announced LHD 8 delay.

Second is the Wedgetail charge, and third is the adjustment to San Diego IT outsourcing contract.

Now I'll walk through each of the four businesses to give a little bit more color.

Beginning with information and services, mission systems had an outstanding strong 11% margin in last year's second quarter.

The change to this year's operating rate reflects a more normal level of contract adjustments than occurred in the prior year.

That is the primary driver of the change in operating income and in rate compared to the prior year period.

Information technology was negatively impacted by the reduction in the value of the deferred costs for the county of San Diego IT outsourcing program.

This essentially accounts for the 100 basis points of decline in information technology's margin rate.

Without this charge, performance would have been comparable to last year's 7.9% margin rate, and as Wes mentioned, we are very focused on improving financial performance at information technology.

This quarter's margin rate is not what we expect from this business.

We are keenly focused on improving performance through better execution on existing contracts, while being more selective as we pursue new opportunities.

The business model used for outsourcing opportunities has been tightened to focus on return on assets, as well as return on sales.

Moving to aerospace, this quarter's 9.5% margin rate versus 10.4% last year is inline with our expectations for this business and it supports our guidance.

The primary driver of the change is the $27 million favorable adjustment we recognized last year for the settlement of prior year's overhead claims in this business.

Adjusting for that item, we would have had margin expansion in aerospace.

Electronics posted a very strong second quarter performance driven by sales growth, as well as margin improvement.

Electronics operating income rose 7% and margin rate expanded by 50 basis points.

At ship building, the decline in margin rate to 7.5% from 9.9% last year reflects the announced step back in booking rates on several programs.

Likewise, last year's second quarter included some favorable adjustments that drove ship building's margin rate up to the 9.9%.

Below the segment line, operating income increased by 6%, generally in line with the organic sales growth and margin rate was 9.3% compared to 9.7% in the second quarter of 2007.

We had improvement of $21 million in corporate unallocated expense and a $41 million improvement in net pension adjustment.

This quarter's corporate unallocated run rate was higher than the first quarter, primarily due to higher unallowable expenses in the quarter.

The other notable item on the P&L is the $14 million increase in other net, primarily driven by gains on sales of assets this quarter versus some losses recorded on sales last year.

These improvements were partially offset by an increase in our effective tax rate to 34.6% this quarter, compared to 29.7% in the prior year quarter.

This year's higher effective tax rate compared to last year's, negatively affected the comparison of year-over-year earnings per share by about $0.11.

Moving on to cash, on Slide Seven, cash from operations was $607 million for the quarter, down from $741 million last year, however last year's cash from operations included $125 million insurance recovery, which we didn't have this year.

And as we have previously discussed, we do expect our cash flow this year to be more back end loaded.

We don't expect the timing of cash flow to impact our cash deployment strategy, however.

This leads me to 2008 guidance for the business, which is summarized on Slide Eight.

Our sales guidance for each of the four businesses as unchanged, other than to reflect the transfer of approximately $1 billion of missile systems business to aerospace from information and services.

So our sales expectation for information and services is now $12 billion to $12.5 billion compared with the prior range of $13 billion to $13.5 billion, and likewise, the sales expectation for aerospace is now increased by $1 billion to $9.3 billion to $9.5 billion compared to the prior guidance of $8.3 billion to $8.5 billion.

The change in these estimates have no impact on our consolidated sales guidance, which remains approximately $33 billion.

Moving on to Slide Nine, our margin rates expectations for the four businesses are also unchanged.

We continue to expect consolidated segment operating margin rate in the high,-- mid to high 8% range, which comprises a low 8% range for information and services, about 10% for aerospace, mid 12% for electronics, and about 3% for ship building, all of which are unchanged from the guidance we have provided on the first quarter call.

Looking at where we are year to date, we will have higher consolidated segment margin rate in the second half of the year.

The year to date consolidated 7.6% segment margin rate is primarily driven by the first quarter charge in ship building.

Through the first quarter, as we are on track for information and services, aerospace and electronics, in order to reach the mid to high 8% range for the year, ship building margin rate will expand as we go through the second half of the year, which is what we have been expecting.

We continue to expect total margin operating rate in the high 8% range, with a tax rate of approximately 34%.

Now, moving to Slide Ten, summarizes our guidance for 2008, our year to date results and our outlook for the remainder of the year support our guidance for sales, segment and total operating margin rates, and earnings per share from continuing operations of $4.90 to $5.15 per share.

Looking at cash, we continue to expect $2.6 billion to $2.9 billion of cash from operations and free cash flow of $1.7 billion to $2.1 billion.

Now Gaston, I think with that, we're ready to turn it back over to you for questions and

Thanks, Jim.

Katina, we're ready for Q&A now.

Thank you.

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Myles Walton representing Oppenheimer and Company.

Please proceed.

Thanks, good morning.

Good morning, Myles.

Ron, I was wondering if you could give us a little bit more color on the DDG 1000 and what it means to Northrop currently in terms of P&L impact and also just from a standpoint of overall structure of the shipyard, this kind of -- would it be, number one, a major disruption to switch back to the 51s and overall for your business, would you see this a positive, negative, neutral, or a negative that you can work through pretty quickly?

Well, Myles, obviously this is still a work in process, and the time cost associated with the decision like this is long and the impact as it works its way through the shipyard is much, much longer.

At the first order, we're not concerned one way or the other.

We think it's probably about neutral, because what we believe will happen is that over time as -- if this in fact is the decision, and there's no guarantee it will be, by the way, because as I said in my comments, the Congress will weigh in on this.

But if it is the decision, then there will be some lead time associated with getting the DDG 51 line extended and also there's a whole lot of work ahead of us on the DDG 1000.

As you know, we're doing work both for ourselves and in support of our partner at Bath.

We're going to support the Navy whichever way they go.

Obviously the industrial base considerations have to factor into it.

We're not going to be bashful about our concerns, but at this point in time, this doesn't keep me up at night.

Okay.

Integrated systems had really nice sales growth in the quarter, even in spite of JSF ramp-down in the R&D, before you ramp back up into production.

When exactly is the inflection point for the F-35 that would go back towards growth for you?

Is it 2009?

Basically 2009, yes.

And then maybe lastly, and then I'll get out of the way, in terms of the charge that was taken on Wedgetail, Wes, was that charged just for the delay of the, of your effort in keeping the work force moving, or was it anticipated that there was a portion of liquidated damages that would be assessed?

Myles, when we look at taking a charge like that, we look at all of the factors.

Clearly we look at the risks and delay, as well as our liabilities associated, potential liabilities associated with things like liquidated damages, so it was a composite view.

Jim, did you want to--

We looked at all the risks, considered all the risks.

Okay.

Based on that, the charge was taken.

I didn't get a chance to read the Q, but would it say 40 million is still the number?

Actually we think the number is a little bit less, and at this point with -- yeah.

Okay.

Thank you.

Thank you, Myles.

The next question comes from the line of Ronald Epstein representing Merrill Lynch.

Please proceed.

Yeah, good morning, guys.

Good morning, Ron.

When we step back and look at the quarter, I think in most of the business units year-over-year margins are actually down.

I guess from a broader perspective, the investment community's been pretty patient in kind of waiting for things to turn.

When would you expect to see that to really be reflected in the financials?

Margins start going up sort of across the business units?

Ron, if you look at the absolute numbers, you're right.

Margin rates are down.

There are explanations obviously for those changes.

For example, the $27 million one-time overhead settlement, prior year overhead settlement in IS, so, I can agree with you the margin rates on an absolute number are down.

There are reasons for it.

This is a long cycle business.

I do think we are really focused on execution.

We are making the right decisions.

Those improvements will show up over time and, management is really committed to driving the long-term opportunities in this business.

So I guess another way to phrase it, when would you expect the special stuff to just get washed out and just we start to see the execution in the business unit shine through?

I mean to be blunt, across the large cap defense sector, many of your competitors in the large cap defense group had outstanding quarters with excellent operating execution.

So it -- you guys kind of stand out a little bit because the margins seemed to drag a little.

And my sense is investors may be getting impatient.

I guess, how do I phrase it, when will we really start to see that shine through?

Ronald, frankly I think we have a different mix of business than many of our competitors.

We are, I believe, in much more of a development transitioning to production face.

They have much more of a production phase mentality.

Production programs are very healthy historically for the industry.

That's where industry does very well, and, and so I feel real good about our position it today and what it means for our future.

We do have a few of these problems, if you will, from the past.

We're dealing with those, but that doesn't diminish my view of what the opportunity is for this company.

Okay, great.

And then just one more question for Ron, if I may.

To follow up on Myles' question on the DDG 51, if the 1000 were to go away, I mean what do you think it means for CGX?

Weren't they supposed to use the same hull?

I think there's a lot of debate going on right now, Ron, on what CGX should be.

I think there's general consensus that it has to have an air defense or missile defense mission.

There are different views of whether that should be the same tumble hull form, whether it should be a different one.

There's even a new dimension which has been added, should it be a nuclear-based ship or a nonnuclear-based ship.

That's going to be a trade study that's going to go on for the next couple of years, I think, as the Navy sorts all that out.

And obviously we're a participant in that in terms of providing our best suggestions, but the Navy's really going to have to sort all that out.

So I don't know the answer.

I do think that there's a strong compelling view both in the Navy and in the Congress that there must be continuity of production in the shipyards involved - i.e., Pascagoula and Bath - and I think there's a strong understanding that those are national resources, and if we decide to stop after a total of two DDG 1000s, the DDG 51s are going to have to come and in fill the gap and the Navy, by the way, does need ships.

So we'll watch this thing play itself out.

We're not lighting our hair on fire.

We're just proceeding.

Great, thank you.

The next question comes from the line of George Shapiro representing Citi.

Please proceed.

Good morning.

Good morning, George.

Good morning, George.

Jim, in the cash flow, you had mentioned in the first quarter that you expected the receivables to come down in the second quarter, certainly to $200 million you attributed to the SAP.

And yet receivables didn't come down, which looks to me like part of the reason for the weak cash flow.

So what happened that it didn't come down, and why do you obviously think it's going to happen in the second half of the year?

It didn't make quite as much progress as we had anticipated.

We did make progress.

You know this business well, George.

Cash is very lumpy.

As I look forward, I feel good about the second half forecast basically, because I compare July results to July last year, actual cash receipts, generally in line with what we experienced last year.

Historically, the industry does well in the third quarter simply because at the end of the government fiscal year.

We do well in the fourth quarter because we are shut down for 10 days to 2 weeks around the Christmas holiday, so we have less cost input and essentially a lot of cash collections occurring during that time period.

So, everything I see tells me that our expectations for strong second half cash flow is reasonable, it is based on our experience.

As I said, July cash receipts are generally in line with cash receipts last year.

So all the indicators are good.

Yes, we didn't make quite as much progress as we had hoped on getting all those SAP receivables collected, but, again, that's an opportunity for the second half.

So I feel good about where we're going to go.

Okay, because I mean obviously you got to meet a pretty big number for the second half of the year to get even to the low end of your guidance.

Yeah, not only do I recognize it.

Everyone in the Company recognizes it and is incentivized to go get it done.

Okay, and then electronics, once again, we had relatively slow growth.

Looks to me like it's a stretch here to get to your $7 billion to $7.2 billion guidance for the year.

I mean what happens in Q3 and Q4 to really get a step up in the growth rate?

The electronics business, George, is part of our business that uses units of delivery more than anyone else to recognize percent of completion.

And historically that electronics business has high fourth quarter units of delivery essentially tied to the budgeting processes of our customers.

And so every -- again, what we see in terms of our expectations based on the contracts we have is that we will have high fourth quarter units of delivery in the electronics business that will help, if you will, bridge the gap or the growth in revenues to the fourth quarter.

Yeah, let me add one thing as well, George.

It's Wes.

If you look at the year-over-year growth in backlog in electronics, it's up substantially.

It's up over a billion dollars year-over-year.

So we're continuing to see the growth in the backlog and that will then -- you'll start seeing that come through in our top line.

It takes a little while to transition backlog into the top line, but this is a business that's growing and we're pleased with how it's doing.

Okay, and then just one last one, Jim.

You had mentioned in response to a couple questions after the first quarter that the margin in ships would probably be somewhere around 8.5% in Q2 to Q4 and this quarter was obviously 7.5%.

So was there some other down ticking in the margin accruals on other programs in this quarter?

Or what caused this quarter to be less than what the thinking was before?

Yeah, George, I guess I can go back and check the script.

My recollection is that I said that it would be -- it needed to be 8.5% for the balance of the year to get to 3% and that we expected it to trend upward as we went through the year.

And there are always, in terms of this quarter, there are always little nits and gnats if you will around contract adjustments, so we did have some of that.

Again, I feel good about the margin rate for the ship building business of about 3% for the year.

So were the contract adjustments this quarter effectively further lowering the margin accruals on the other programs, or they were just more one-time kinds of items?

I would consider them more one-time type items.

Okay, thank you much.

George, ups and downs, frankly.

Okay, thanks.

The next question comes from the line of Doug Harned representing Sanford Bernstein.

Please proceed.

Good morning.

Good morning.

I just want to follow on that last question.

In your earnings release, you said that in ship building that lower operating income reflected additional costs for schedule impacts to several ship building programs as a result of resource constraints.

Are those issues that are in addition to what you saw when you took the $320 million charge?

Is there something -- is there something more going on with those other ship building programs than you perhaps expected last quarter?

Generally consistent with what we expected last quarter.

As I said, we always have in every business in every quarter contract adjustments up and down.

We had some of those in the ship building businesses this quarter as well.

But again, as I said in terms of my view of the -- about 3% margin for the year, I think we're okay.

I'm just trying to understand how things are proceeding in the Gulf, because my impression--

I think, as Wes said, our focus clearly has been on LHD 8, weekly reviews with Mike and the team.

The team is making really good progress.

I would add that one of the important actions that we've been taking is to make sure that we are balancing the application of resource across all of the programs there.

We continue to work closely with the Navy to make sure that the priorities are aligned with their needs.

As we do that dynamic balancing, we on a continuous basis shift the applications of those resources, so I think that's working well, and, your broad question about how are things going in the Gulf, I give that team a lot of credit for the progress they are making.

I think we're on the right track and consistent with the guidance we've given for the performance that we expect out of the Gulf this year.

Okay.

Then on information technology, you described the issues in San Diego county on cost as being what led to some lower margin levels than you might have expected.

Could you describe how that program is going right now and how confident you are that you've basically made the adjustments you need to make and that we won't see something like this happen further down the road.

Yeah, Doug, as Wes said in his comments, we've looked at the revenue projections for the five years of the contract and essentially lowered those slightly, which essentially resulted in the reduction in the deferred costs associated with the program.

The program itself from an operating perspective is doing just fine.

But are you through the transition period where you feel you've pretty much established your cost base and you know what that will return?

We are through the transition period, and maybe I need to be clearer here and more blunt.

You need to estimate your revenues and your costs for the five-year remaining portion of the contract.

We feel good about our cost estimates, as well as our revenue estimates based on what we see today.

But we all know IT needs will change over time and frankly, I think there is a good possibility that those revenue estimates will increase as we go through time and as the county addresses their needs.

But based on what we see today, we reflected what we see today in our revenue estimate, as well as our cost estimate.

Okay.

Very good.

Thank you.

Thank you.

The next question comes from the line of Rob Spingarn, representing Credit Suisse.

Please proceed.

Good afternoon.

Just going back to the Gulf Coast again, I know we've asked about this a few times, but Wes, are you saying that collaterally, any kind of delays to the programs are modest and accounted for here?

Yes, that is our view.

As I said, we do a continuous and dynamic assessment of how we're allocating the resources, but as we've gone through that, I think we have developed a very robust view of how we're going to complete all of the ships that we have in the inventory in the Gulf Coast.

We've been working that closely with the Navy.

As you know, the Navy's needs are clearly an integral part of our thought process here because these are ships that the Navy's counting on for deployment.

And so that has to be a factor as we consider how we go about not only finishing off LHD 8 but finishing off the other things that we have in the inventory in the near term.

And so we have a robust plan in place.

We've made those resource allocations.

We're managing to it very precisely.

As I said, we feel good about how the team is doing in the Gulf Coast addressing that full set of opportunities.

Okay.

So on that basis, Jim, your guidance implies a margin basically around 9% rest of the year.

Do you feel comfortable with that?

Yeah, as I -- yes, I do.

And is that a sustainable margin?

Is that what this business should be earning?

We take a clean year like 2009 -- presumably clean, a 2009 year could be 9% all year?

Well, Rob, if I go back to the investor conference, I talked about the ship building business as potentially having 10% plus margins.

I intuitively believe that is the opportunity space that we look at.

It, as I said, this is really a long-term business.

The progress there will take some time, but I do expect us to make steady progress.

So let me ask you the different way.

Is there anything about the mix as you enter the next year that would put negative pressure on the margins exiting this year?

We are going to be completing CVN 77 and moving to CVN 78 new carrier contract, front end of that contract will tend to be a little bit more conservative in our earnings recognition up front on that contract, just because it's at the very front end of the construction, if you will.

So, yeah, there could be some near-term impact to that kind of mix issue.

But on a long-term basis, again, my view of that business is not different than what we've talked about in the past.

Okay, and then just a quick thing, Jim and then a question for Ron.

I can't recall if you've talked about the R&D tax credit in your guidance.

But if you could just refresh us on that.

Yeah, our tax rate guidance does not include the 34% number for effective tax rate for the year, does not include the potential benefit of a reinstatement of the R&D tax credit if that were to occur.

And can you quantify what that would be?

Again, if it goes back to the beginning of the year, historically we've -- the R&D tax credit has given us about a half a percent in terms of our effective tax rate.

Okay.

Thank you.

And then, Ron, if you could just speak to your international opportunity set, I think you're just under 10% international, maybe closer to 7% or 8%.

But maybe what some of the opportunities are there, thank you.

Well, it is closer to 7%, and it continues.

I see it kind of growing in proportion to our sales - overall sales growth here, Rob.

I don't see it growing faster or slower.

There's opportunities in IS obviously and in electronics systems.

Those are probably our two major plays.

We're also looking at some opportunities in IT and MS, but I would say that in the next couple of years, we would probably see a continued proration of the amount of international business we have today, just on a larger base.

Is there anything specific in the surveillance area, the JSTAR and some other things out there?

Well, we have obviously the MESA programs which are going now successively to places like Turkey and Korea.

We have E2 opportunities in (technical difficulty) south Asia.

We see some Global Hawk opportunities as well, so we have a variety of things which we're looking at.

More F-18 sales will be helpful to us and a variety of work we're doing in the Middle East with our allies there.

Okay, thank you very much.

Thank you, Rob.

The next question comes from the line of Heidi Wood representing Morgan Stanley.

Please proceed.

Good morning, guys.

I confess, I do have a shipbuilding question, but I will ask some others first, just so I don't exhaust you totally.

Can you talk a little bit about mission systems and give us a little more color on the margins there and describe what's happening in terms of work at mission systems?

I'm sorry.

What was the last part of that, Heidi?

The -- work, Jim, how are you seeing the specific mix of work at mission?

I don't know that I am seeing a significant chain -- excuse me, Heidi, in mix of work at mission systems.

As I said in my comments, the 11% margin last year was very high for that business.

It did reflect a greater amount of favorable contract adjustments than what we would normally expect to have in that business in a quarter.

So, it essentially is just the wind down last year of a couple programs versus what occurred this year.

Okay, and on F-35, my understanding is on the FCD phase, Lockheed does not book a fee on your portion of the work.

First of all, I would love to get color on the performance grades you're getting on your customer on that.

And secondly, as their negotiations are happening to full rate production, I know Lockheed's trying to get fee-on-fee on your work.

Do you have any say in those negotiations and does it have a different margin implication on whether you continue to go directly with your customer, or if you go through Lockheed on the full rate production phase?

Well, Heidi, I can't conceive of any scenario in which we would not work closely with our customer as there's a part - that's how we entered the job years ago.

It's been a great partnership.

In terms of the fee-on-fee, I have no visibility into that.

That's not something I know about.

I can tell you that our relationship has been strong.

Our performance on our part of the program has been extremely strong.

We are in good pre-production activities in Palmdale, very strong engineering connection with the whole team.

So overall, I'm very pleased at how things are going.

I think we're very much in lock step.

I would say the integration of the management of this program's as good as anything I've ever seen.

Okay, and the two contracts that are being protested - BAMS and tanker - did you keep them in backlog?

Yes, we did.

Okay.

All right.

So now, I'm sorry, but I kind of want to also understand ships, so I have to harken a little bit off of Rob's question just to make sure I understood it.

The -- Wes, you talked about successful completion in electronic cabling sort of being a pivotal point in the third quarter and that it looks like again, per the release that you had some schedule impact on the ship programs due to LHD 8, so is it a correct read to understand that you need this to be successful in order to remain on schedule at the other ship programs and therefore these ship margin rates you're assuming for second half of '08 is kind of contingent on this?

Heidi, let me harken back to what we said at the end of the first quarter when we went through a somewhat detailed description of the LHD 8 set of issues and the related implications and other programs.

Because we extended the LHD 8, schedule as a result of the cabling issues that we found earlier this year, we had to deploy resources onto LHD 8 that were otherwise intended to go to the other ship programs.

So when we announced the issues associated with the 8, the charge for the 8 and the schedule delay for the 8, in parallel, we talked about the implications on the other ships in the yard down in Pascagoula primarily.

And since that time, we have been executing on that schedule that we laid out.

We have been working with the Navy to make sure that the application of those resources as they are coming off of the 8 are prioritized in the right directions onto the right ships and the financial projections that we've laid out, that Jim described a little bit earlier, are all consistent with that perspective of the delayed application of resources to the other ships relative to where we would have been earlier in the year prior to the discovery of the issues on the 8.

Right, but, Wes, what I don't feel like I understand is do you feel that you need the same resource intensity in the second half of the year as you complete this program, or does the mechanics of what you do, mean that you don't have the same intensity?

No, we've been rolling people off of the 8 already, Heidi and as we go through the year, we'll continue to reduce the manning on the 8, apply those resources to the other ships, and actually that helps support the testing program as it gets under way by having less people on board the ship.

So that's all an integrated plan and we're executing to it on plan so far.

Okay, and, Jim, you talked about your confidence in ships being a 10% margin business.

But it appeared to Rob's question that you somewhat demurred on visibility on 2009.

Is it a fair read that these more normalized 10% margins are more achievable in 2010 than to be expected in 2009, or can you give us a little more color on your expectations next year?

Heidi, we haven't given guidance on 2009 and I was talking long-term in terms of my opportunity, or my view of where I see ship building margins going, so I'm going to defer 2009 until we give full guidance for 2009, and as you recall from our investor conference, margins in ship building in 2012 - our targets, goals for 2012 were not at that 10%-plus margin range.

They were more like 10%, as I recall.

And we talked about opportunities to improve margins beyond that to potentially 10% to 11%.

Again, this is a very long-term business.

Great.

Thanks very much, gentlemen.

Thank you, Heidi.

The next question comes from the line of Joe Nadol representing JPMorgan.

Hi, Joe.

First question is back on ships, but it's not LHD 8 or the margin.

It's actually on sales.

I'm just wondering why with the strong quarter and, Jim, the reasons you gave that sort of the math you gave on the 13% adjusted organic growth, but why the back -- your guidance implies the back half is down so much from last year.

I mean even down sequentially second half from the first half.

Yeah, you know, Joe, in a way it goes also to Wes' comments, or answers to Heidi.

Essentially as you know, we essentially have a stable workforce in the Gulf Coast.

We are working more overtime right now to help complete a number of ships that are very close to either builders trials or acceptance trials.

And so I do expect as we go through the balance of the year that overtime may come down so the cost input, if you will, on a number of ships will be lower in the second half than it is -- than it was in the quarter.

We will be more complete on LHD 8, for example, and so as we go through time, I do expect the pace of cost input to slow as we go through the year, resulting in lower sales in the second half.

Is that -- how does that play into margins?

Because one would think with a little bit less leverage on your overhead, maybe doesn't matter because it's all kind of in contract accounting anyway but (multiple speakers) kind of hurt you?

It does -- you're right, it does not matter.

We've considered potentially lower overtime into our cost estimates as we've looked at these programs, and so we essentially will have the same margins, whether or not we work the overtime.

It's just essentially schedule-driven, if you will, how we mitigate our - pull schedule forward or leave it where it's presently planned.

And then on DDG 1000, just to try to quantify that a little bit, is this -- is it fair to say that's -- if there were a shift, it would start to impact you probably in 2010, but directionally, it's still kind of tough to say, just depends on a lot of unknowns?

Well, first of all, let me make it clear, there is a rumor and a very short release indicating that there was a thought about doing this.

Best I can tell, both the House and the Senate appropriation marks have long lead funding in them for the third DDG 1000.

So I think we've got the usual public debate ahead of us for a while, but assuming it happens, you have to recognize that you get more margin on the -- sorry, more sales volume on the DDG 1000, but we will typically make more margin on a DDG 51.

So even though there's less sales volume and typically you'll probably see more DDG 51s in replacement for whatever DDG 1000 would not be purchased.

So I think we're really basically playing contingency games at this point in time.

But as I indicated, the time constants are long enough here that we don't have a great deal of angst associated with this.

We'll work through it with our customer and over time we'll see where it takes us.

And the great thing we have going here is that our shipyard is capable of producing either class of ship and we think it's the Navy's job to decide which ones they want.

Ron, just one more on that.

Would you anticipate that if we did go back to DDG 51s that they would be kind of an updated design or do you think it would be the ones -- very similar to the ones you already have in your backlog in terms of systems?

Well, Joe, that's hard to speculate.

It's a great ship now.

It has a great modern design and it will be what it is.

If it's going to be the same ship, that's great.

If they want to put some improvements in it, that's fine.

We certainly know how to build it.

Okay, and then just one more over on electronics.

If you ex out the Wedgetail charge, you were very consistent with the margins in the first quarter; 13.3, 13.4 is kind of where you're running.

Obviously your guidance for the year calls for lower margins in the second half.

Jim, is that -- is it fair to say that's contingency?

You do have these programs you update us on every quarter, Wedgetail, Block 60 and a couple of others, and in a best case scenario, your second half margin could kind of be in line with what you did in the first half, ex the Wedgetail charge?

Mid-12% is a trying to look at everything we see, that is our expectations for the year.

You're right, it could mean that margins come down in the balance of the year.

Will it actually happen?

I don't know.

But as I look at the business, mid 12% range makes sense to me.

Remember as well that we had $19 million of additional royalty income in the first quarter, which effects margin rates somewhat.

So, whether we're going to have the same amount of royalty income in the second half of the year, at this point, I don't know, Joe.

Joe, I guess one other little flavor to it, as I indicated earlier, we've had quite a bit of success over the last year and a half in capturing really good solid backlog in electronics.

Our team is firing on all cylinders, addressing its marketplace.

Some of the things that we've been capturing are developmental programs that later transition in production and so we'll watch as that mix shifts in and that could have a little bit of impact here.

But overall, I think we would all characterize electronics as an organization that's performing extraordinarily well.

Okay, good.

Thank you.

Thank you.

The next question comes from the line of Richard Safran representing Goldman Sachs.

Please proceed.

Good morning.

Good morning.

Just wondered a quick question, if I could, on share count.

If I'm right, I think you said previously that full year share count would be down around 2% for the year, and it looks like you're already ahead of that year to date, if I use your share count at the end of 2007.

Do you have any revision to your share count guidance for the full year?

And I guess more importantly, should we be as a result of this, should we be expecting some kind of change in your cash deployment strategy?

Rich, you're right.

We're down about 3% versus the 2% estimate.

We spent 800, a little bit over $800 million on share repurchases year to date, so essentially in the six months, we've completed a third of the program that we announced last year.

As I said in my comments about cash deployment strategy, we don't expect that the timing of cash flow will impact our cash deployment strategy.

I don't have a new forecast of share count number, but, you know, essentially it all went into our $4.90 to $5.15 range for earnings per share for the year.

Okay, thanks.

And lastly, one bookkeeping question, could you tell me for pension what your return on plan assets were for Q2?

For the quarter -- well, let me answer it year to date.

Sure.

For the year to date, we are negative about 4.5%, so pretty, you know, far off our long-term expected rate of 8.5%.

But actually better than our benchmarks.

Okay, thank you very much.

Thank you, Rich.

The next question comes from the line of Cai von Rumohr representing Cowen and Company.

Please proceed.

Thank you.

Why is cash allowable plus of 69 million in the second quarter, up 10 million from the first quarter.

Why and where do you expect that to be for the year?

The why is essentially finalizing our cash allowable expenses, so there was an improvement of about $10 million in terms of cash allowable costs from our original estimates for the year, $10 million on a year to date basis booked in the second quarter.

On a go-forward basis, I would expect the net difference to be about $5 million off the pace of the second quarter.

So really just add $5 million to each of the third and the fourth quarter essentially from where we were?

Well, I guess I don't know where you were.

But -- Take 5 off the second quarter.

Got it, okay.

Got it.

And then on the San Diego, you kind of mentioned $12 million, was that a (inaudible) charge, or was that just kind of a look-forward change in accrual rate?

(Inaudible) catch adjustment.

So on a go-forward basis, it should be more profitable than it was in that quarter?

Well, more--

Or less unprofitable?

Let's see, the San Diego program essentially has zero margin.

Okay.

So this is, again, a consume catch adjustment that did contribute to negative margins on the quarter.

On a go-forward basis, I would look for them to have basically zero margins.

Got it, okay.

And last one, if we look at ISG, the upper end of your guidance is that revenues will be $9.5 billion.

To get there, I mean you would have to be down in the second half from the first half.

Is that conservative, or if you're going to be down the second half, is it going to be integrated systems and space and why?

Cai, there can be movement around this guidance, a small amount.

Again, I feel pretty good about the $33 billion.

Some of the sectors are going to be at the upper end of the guidance and I think maybe one of them may be at the low end.

But on an overall basis, rather than pick on individual sectors, again, the $33 billion feels really good to me.

Some of them are going to be -- some of the individual segments are going to be high end and some of them are going to be low end.

Some of them may actually beat by a small amount.

No, no, I can understand that, but you gave a good answer in terms of why electronics should be better in the second half, a good answer why ships should be lower in the second half and so there must be a reason because, this is at the upper estimate.

You have to be couple hundred million, or 250 million lower than you were in the second quarter and lower than you were in the first.

So I mean are there any one or two factors that if you were at the upper end of your guidance for that sector, that would have you down in the second half, or is it maybe a conservative estimate?

Maybe a conservative estimate, by $100 million, but, these are really big programs and the timing of cost input into those really make a difference into what is recognized as sale.

Okay, excellent.

Thank you very much.

The next question comes from the line of Troy Lahr representing Stifel Nicolaus.

Please proceed.

Thanks.

Just wanted to drill down a little bit on the integrated systems, the margins sequentially down and year-over-year down.

Is this just a mix shift?

Is that really all that is and just timing and eventually that should start swinging back again?

Troy, basically is due to the $27 million one-time favorable resolution of prior overhead issues that occurred in last year's second quarter.

But for that item, aerospace margins as well as integrated systems are actually up.

Okay.

So there was also then one-time items in the first quarter when they were 12.7?

I'm sorry.

Were you referring--

I'm saying year-over-year they are down and sequentially quarter over quarter they are down.

First quarter you did 12.7.

Were there just some one-time items in there in the first quarter?

There are always earnings on individual contracts.

We look at our EACs on a staggered basis as we go through the year and so that -- the adjustments on individual contracts can have an impact on quarterly revenues and earnings and the change from one quarter to the next.

Okay.

So outside of some one-time items, we should generally view integrated systems as this is kind of a sustainable 10.5% run rate.

Is that the way I should look at this business?

I think our margin, our guidance for this business is -- for aerospace is the 10% margin rate.

Okay.

And JLTV, do you have an update on the down select and what you're seeing on that?

Has that gotten shifted out a little bit, pushed out to the ray a little bit?

Yeah, Troy, that is Ron.

It has been.

We believe there is the source selection process is well along.

I think the issue is the desire on the part of the Department of Defense to have the Army award perhaps three parallel contracts, not just two, and so there's a matter of making sure the funding is in line.

I think it's another $60 million or so interaction going on with the Congress, the budgeting process, and we've seen that moving to the right.

I think the program is still extraordinarily high priority.

The idea of having three is to really allow the broadest range of technologies in the mix as early as possible, given that this thing is going to be bigger than tankers probably when it's all finished in terms of the number of vehicles produced, the amount of money spent on it.

So, and as you know, there are about six of us in the running and we're very excited about our offering and we'll see how it plays out as we get into the fall.

Okay so.

You're thinking like September, October, November for a down select, then?

Yeah, I guess, but I will tell you, long ago, decades ago given up forecasting when procurement's down selections will occur.

Okay, thanks, guys.

Thanks, Troy.

The next question comes from the line of Robert Stallard representing Macquarie.

Please proceed.

Good afternoon.

Hello, Robert.

I won't ask you about ships.

Yea!

I thought should I follow up on Wes' comments about information technology and the opportunity there to improve the margin.

What sort of benchmarks are you looking at on the target margin, what -- how -- achieve this given the cost-plus basis on some of these contracts?

That's a really good question.

It really goes to the types of mix of businesses that we pursue in the IT space.

We have some, as you know, some very high margin businesses associated with some of the technical professional services capabilities we provide in the intelligence arena.

Blend that with some of the much lower margin businesses that we have in the IT outsourcing businesses, and the, I would say more moderate margin rates that we get, as you referenced, some of the Cost Plus business where we take on development activities and provide large scale software solutions to a number of large enterprise customers and the federal government.

So going forward, as we look at that market space with those -- with that wide variance of different rates, when we make our decisions about our portfolio mix, we're looking at both the actual margin rates themselves, as well as the returns we generate on some of these contracts.

So I -- if you were asking for a specific number, we've talked about the mid to high single digits, but it's that blend as we go forward, that will shape where we actually end up in that range.

And we are taking a -- I would say a very economic view of making those decisions based on both the margin rates themselves, as well as the actual returns that we get out of it.

You know, if we wanted to shape this solely around returns, we could, of course, get this into the high single digits and in some cases into the low double-digit margin rates.

And we have that opportunity, but we think we can actually do better in the overall economics of the business by being attentive to both the return side of the equation as well as the rate.

I presume it's going to take a while to work off some of maybe some of the lower return programs, so this is probably a long-term--

Well, it takes a while, but the IT business has a much faster cycle on its program base than our large hardware businesses do.

In fact, I think the average span time on a large fraction of our contract base in IT is measured in months or a small number of years.

So the turning radius isn't quite the same as it is in our aircraft business or our ship building business.

So we have a little bit more opportunity to see a faster rise time.

Okay, that's great.

Thank you.

Thanks.

The next question comes from the line of Harry Nourse representing Banc of America.

Please proceed.

Good morning.

Good morning, Harry.

Could you just tell us, is the amount of Katrina-related revenues next year still expected to be about $350 million, or is that changed?

Essentially about the same, yes.

About the same, excellent.

And looking ahead to 2009, obviously your long range plan calls for an average of 6% sales growth.

Is that the right area for next year and perhaps you might have an idea of which areas of the business might be growing faster than others?

I don't think we can give guidance for '09.

We did layout some objectives for 2012.

And I think you can look at those and make some adjustments, but we're not prepared today to give guidance, Harry, for '09.

You couldn't tell us which areas might be growing faster than others or just any indication?

I don't think so, not today.

Okay.

Thanks.

Okay.

Let me just wrap up.

I think we're already over the hour.

This was a solid quarter.

Second quarter came in well for us, we believe.

We're looking for strengthening our margins and our cash in the second half.

I'm very comfortable with achieving the 2008 guidance we've laid out, and with that, I would like to end the call and thank you all for joining us.

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

This concludes the presentation.

You may now disconnect.

Good day.