諾斯洛普·格拉曼 (NOC) 2008 Q3 法說會逐字稿

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

I will be your coordinator for today.

(OPERATOR INSTRUCTIONS)

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

Gaston Kent, Vice President of Investor Relations.

Please proceed.

Thank you.

Good morning everyone.

Welcome to Northrop Grumman's Third Quarter 2008 conference call.

We provided supplemental Information in the form of a PowerPoint presentation that you can access on our Investor Relations website at NorthropGrumman.Com.

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

Before we start, please understand that as shown on slide two, some of the items 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.

During call we'll discuss third quarter results including the non-GAAP measures, segment operating income, and segment 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, earnings per share from continuing operations, cash from operations, and non-GAAP measures, segment operating margin rate and free cash flow.

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'd like to turn the call over to Ron.

Thank you, Gaston, and hello, everyone.

Thanks for joining us.

We're very pleased with our strong third quarter results.

Sales and earnings per share both grew by 6%.

These are solid improvements but the highlights this quarter are cash generation, new business awards, and our record backlog.

Cash from operations totaled $1.4 billion and free cash flow totaled $1.2 billion.

Strong cash generation and our ample liquidity supported the continued execution of our balanced cash deployment strategy.

During the third quarter we purchased more than 10.8 million shares of our stock bringing our year-to-date share repurchases to approximately 21.2 million shares.

At the end of the quarter we had approximately $960 million remaining on our share repurchase authorization.

Shortly after the end of the quarter we purchased 3001 International, a strategically important IP sector acquisition that will significantly complement our current core geospatial business with its strong geospatial data collection processing and production capabilities.

We ended the quarter with a record backlog of more than $70 billion.

New business awards in the quarter totaled $11.5 billion and include new competitive awards as well as follow-ons to some of our large franchise programs.

This brings year-to-date new business awards to more than $31 billion, nearly equal to our 2007 annual sales.

During the quarter, we were awarded a $5 billion cost type construction contract for CVN78, the USS Gerald R.

Ford, the Navy's next generation aircraft carrier.

Our second quarter award of the Navy's $1.2 billion Broad Area Maritime Surveillance contractor BAMS was upheld by the GAO and we're under way now on that program.

In addition to new awards we also achieved some notable program events during the quarter including completion of the electrical cabling milestone on the LHD8.

We're very pleased with how that program is progressing and we have increasing confidence in the delivery schedule for this ship.

Wes will provide more color on this in a minute.

I also want to take a minute to comment on the Air Force Tanker program.

Clearly, as the winning bidder, it's disappointing that the competition has been deferred.

We are also genuinely disappointed on behalf of the men and women who urgently need a new tanker.

The Air Force chose the right tanker during the first competition and we are convinced that when we compete again, we will win again.

We continue to have a very robust opportunity set in addition to the tanker.

The down select on the multi-billion dollar joint light tactical vehicle program is imminent.

Also on the horizon are programs like Aerial Common Sensor, GPS Next Generation Ground Control segment, Vehicular InterCommunications Segment Next Generation, and other substantial new opportunities including restricted programs.

Before I conclude I want to take a moment to comment on the turbulence in the capital markets, the responses from the Federal Government, and how Northrop Grumman is likely to fare going forward.

Our business is characterized by long term contracts that support national security priorities.

We believe military spending priorities and specific program spending plans are primarily threat-driven.

These threats will exist regardless of the changing political or economic backdrops.

Overall, Northrop Grumman's programs were well funded in the recently passed 2009 defense budget.

While we are mindful that the higher level of Federal Government spending through the emergency Economic Stabilization Act and other federal financial support programs may pressure defense spending, the budgetary process gives us good visibility regarding future spending and the threats being addressed.

We believe that our strong contract backlog is well aligned with the direction of our nations future security needs.

The recent market turmoil has demonstrated the importance of liquidity and access to the capital markets.

It has also heightened our level of vigilance regarding the financial health of our suppliers and our pension plan investment returns.

While no business is completely immune to these pressures, we believe our backlog, cash generation, and credit facilities will allow us to continue to grow despite these challenges.

So in conclusion, this was a strong quarter in which we generated higher sales, earnings, free cash flow, and new awards.

Based on that strength, we are raising our 2008 guidance for sales and earnings per share.

Now, I'd like to turn the call over to Wes Bush.

Wes?

Thanks, Ron.

Hello, everyone.

My comments today are outlined on slide four, and will focus on two key thrusts of our operating improvement efforts.

Business capture and program execution.

We've put tremendous effort into enhancing our business capture operations over the past several years and the results are showing.

A key indicator of course is the growth in our contractual backlog which now stands at over $70 billion.

Key wins this year such as BAMS demonstrate the competitive improvements in our process, but as importantly, we're driving to improve the quality of our new contracts through adherence to our new, more stringent bid criteria.

We are not bidding on programs unless they meet those criteria and you could see the effects of this, for example, in our declining sales and backlog in the commercial, state, and local business of our IT sector.

So we're being more selective.

Our total backlog is growing, and the quality of that backlog is improving.

Program execution is also a key operating priority in the Company, and here too, we're making progress in our portfolio of over 20,000 programs as we integrate stronger risk management methodologies into our program management processes.

We're making good progress in retiring risk on our key watch list programs.

On Block 60 we met our milestone for delivery of the EW3 software in the quarter and we continue to perform to plan.

On Wedgetail, we're ready to enter type acceptance testing once clearance is obtained from the customer and we've reduced the staffing on the effort while we await this go ahead in order to maintain performance within the EAC.

During the quarter we undertook an extensive review of the risks on the New York City Wireless Program and we determined that while we're making very good progress, cost to complete the work has increased.

Some of this relates to our estimate of additional costs that we may incur to ensure that we can obtain the equipment and the support that's needed to complete the program from a key subcontractor who is currently experiencing some financial difficulties.

In addition to these potential subcontractor related costs, the provision also reflects a revised estimate to complete the program.

As build out has progressed we've encountered cost growth associated with site completions and some slower regulatory permitting, which has extended the network completion schedule into the first half of next year.

We believe this revised estimate appropriately reflects the remaining work as we've made good progress towards completion of the program.

The technical performances outstanding, and we've already achieved 90% coverage of the city with the network.

Our ship building team is making solid progress.

Our submarine and aircraft carrier programs are going very well.

We suffered some down time in our Gulf Coast operations due to Hurricane Gustav and Hurricane Ike caused damage at a subcontractor facility that builds compartments for LPDs 22 and 23.

Our team has taken aggressive management actions to minimize these hurricane impacts.

I'm very pleased to report on the outstanding progress that we're making on LHD8.

Timely accomplishment of the third quarter electrical cabling milestone was absolutely critical and it fully supports our delivery timeline.

As a result of this progress, we returned some program reserve to profit in the quarter.

We're on track to complete the pure site integration propulsion testing this quarter as well.

Based on this excellent progress to date, we're working with the Navy to potentially accelerate builders trials and trial readiness reviews are already under way with the Navy's program team.

So despite some issues including some externally driven challenges, we're making good progress and continual improvements in program execution and the quarter results demonstrate that the portfolio is operating well.

So with that, I'll turn it over to Jim.

Thanks, Wes.

Good morning, Ladies and Gentlemen.

During my comments, I'll discuss sales and provide some color on margin rate and cash trends and then I'll review 2008 guidance and then provide some thoughts regarding 2009 trends with some particular discussion on 2009 pension expense.

To begin on slide five, I want to provide my perspective on what is a very strong quarter.

Our underlying fundamentals continue to be very strong as evidenced by higher sales, net earnings, free cash flow, record backlog, strong liquidity, and access to capital.

Earnings per share are 6% better than last year.

Last year did include a $0.06 per share gain from the AMSAC reorganization so without that $0.06 gain in last years third quarter earnings, this quarters year-over-year improvement would have actually been 11%.

And when netted against each other, the unusual items in this years third quarter, New York City Wireless, the hurricane impacts that Wes talked about, and the positive items that royalty settlements and tax credits generated a $0.02 reduction in this quarters earnings and the tax credits were anticipated in our guidance for the year.

Risk mitigation and program execution continue to be the highest priority of our senior management team.

Across the Company, we are working diligently to reduce and retire program risk on programs so that our execution and financial results become much more predictable.

This quarter we also took a more conservative approach to program risk assessment, particularly at our Gulf Coast shipyards which resulted in the lowering of booking rates on a number of those programs, and finally, we're working hard to ensure that we negotiate contracts that appropriately reflect the risk inherent in that work.

And as you all know, no amount of good performance can overcome a poor contract.

Moving on to slide six, sales for information and services, aerospace and electronics all up over last year and on a consolidated basis, sales were up more than 6%.

The third quarter sales trends for information and services and aerospace are consistent with what we seen throughout the year.

The increase though in electronics is largely due to increased deliveries, in the third quarter, and the decline in shipbuilding is due to Hurricane Gustav which required the closure of our Gulf Coast shipyards for more than a week and reduced sales by approximately $100 million in the quarter.

Year-to-date, ship building sales were up 11% and for the year, we now expect their sales will total approximately $6.1 billion which exceeds our prior guidance of 5.7 billion to $5.9 billion.

We also expect higher sales for aerospace than our previous guidance which was 9.3 billion to $9.5 billion.

We now expect aerospace sales will total approximately $9.7 billion.

And electronic sales are expected to be about $7 billion.

This is at the low end of our prior range and simply reflects the sale of the electro optical systems business earlier this year.

So based on the year-to-date results and the increased expectations for shipbuilding and aerospace, we are increasing our guidance for 2008 sales to$33.4 billion.

On a consolidated basis, segment operating margin totaled 9.2% compared to 10.4% last year.

After adjusting for unusual items, the underlying segment operating margin rate this quarter is fairly consistent with last year.

Last years rate of 10.4% when adjusted for the $67 million in shipbuilding positives and a $22 million Information technology charge equates to 9.8%.

This quarters rate would have been 9.7 before the $40 million patent infringement settlement in the New York City Wireless charge and the hurricane impacts.

Below the segment line, improvements in unallocated expenses and net pension expense were offset by the decline in operating income and the reversal of the royalty income leaving us with a total operating margin rate of 9.2% for the quarter.

Looking at the year in total we now expect both segment margin rate and total operating margin rate to be in the mid 8% range.

This adjustment to prior guidance contemplates a margin rate of mid 7% for information and services versus the prior guidance of low 8% and a mid 2% range for shipbuilding versus the guidance of approximately 3% before.

The reduction in the shipbuilding rate is largely hurricane driven.

Moving to taxes.

Our effective tax rate declined to 31.4% in the quarter primarily due to the settlement of TRW tax audits for the years 1999 through 2002 which had been anticipated in our tax rate guidance for the year.

During the third quarter we recognized tax credits of about $21 million primarily attributable to the settlement.

And with the passage of the emergency Economic Stabilization Act of 2008, and the renewal of the R&D tax credit we now expect an effective tax rate for the year of about 33.5%.

Looking at cash on slide seven, cash from operations was just outstanding at approximately $1.4 billion for the quarter, a substantial improvement over last years $1 billion mark.

In the quarter, trade working capital improved by more than $400 million reflecting our continued emphasis on managing working capital as well as the successful resolution of billing transition issues we discussed on previous calls this year.

Year-to-date, trade working capital is essentially flat while the Company has grown by 6%.

After capital spending and outsourcing contract costs, free cash flow improved to $1.2 billion.

This translates to a net income conversion rate of 128% on a year-to-date basis.

Slide eight summarizes our updated guidance for 2008.

We now as I said expect sales of $33.4 billion and earnings per share of $5.10 to $5.20, our guidance for cash from operations remains at 2.6 billion to $2.9 billion and for free cash flow, we have targeted a net income conversion greater than 100% for the year.

The low end or the lower end of our free cash flow range has improved by $100 million to 1.8 while the upper end remains at $2.1 billion.

This cash from operations and free cash flow guidance includes $120 million for required pension contributions.

We are contemplating additional voluntary contributions to the pension plans which would reduce reported cash from operations and free cash flow.

Looking ahead to next year, I'd like to take a moment to provide some perspective on 2009 FAS and KAS pension expense including some sensitivities.

Chart nine in your package summarizes my comments.

As you know, 2009 FAS pension expense will be determined based on actual investment rates for 2008 and the discount rate as of December 31, and as you know, and like many of our peers we have had a long term historical practice of using actual fair market value of plant assets at year-end to determine our next years expected investment returns.

Through September 30, our actual investment returns were a negative 12%.

Although significantly different than our long term investment rate, a return assumption of 8.5% it is decidedly better than the market in general and this return is also significantly different than our long term historical experience.

Over the last 30 plus years, we have realized a compound rate of return of about 11% annually in our pension plan.

Earlier this year, we made a change in our investment policy, significantly reducing the equity weighting.

This has been a beneficial change as equities have under performed the other investment classes this year.

Now, let's talk a bit about how this performance will be reflected in future pension expense.

With the current market volatility a lot can happen between now and the end of the year but we had previously modeled a negative 10% investment return on plant assets for 2008 compared with that 8.5% long term rate of return assumption and a discount rate of 7% versus the 6.25% that we used at the end of last year.

And frankly, if we were setting these rates at 9.30%, the discount rate for example, would likely have been higher, but as I said we set these rates at the end of the year.

But under these modeled conditions and recognizing the differences in the individual plans, our net 2009 FAS, KAS pension adjustment would be an expense of about $165 million compared to income in 2008 of about $250 million.

I think it's also important that I provide some sensitivities to these modeled assumptions.

I must caution you, however that these sensitivities are unique to our situation and this model.

As you may know, cumulative pension gains and losses are first absorbed into a corridor equal to the greater of 10% of plant assets, our projected benefits with any excess gain or loss, then amortized into expense, so these sensitivities are relatively linear once we are outside that 10% corridor.

So with every 100 basis points moved at a variance around the assumed negative 10% investment return, we see a change of approximately $40 million in estimated 2009 FAS expense.

Likewise, for every 25 basis point change in the assumed 7% discount rate, it results in a change of approximately $50 million in estimated 2009 FAS expense.

In addition, if we decide to pre-fund our pension plans between now and early 2009, we would further reduce our 2009 FAS expense by $8.5 million for every $100 million of voluntary pension funding.

In looking at 2009 KAS expense, the required -- and required cash contributions, we do not expect to see the same level of volatility as KAS and cash are less sensitive to the current market movement until we reach a break point somewhere above a negative 20% investment return.

So let me pause and then just transition to some comments about the overall outlook for 2009 .

As you know we will give specific guidance with our fourth quarter earnings call as is our normal practice but I'd like to give you some indication of trends that we currently see.

Regarding total operating margin rate as we discussed given the current market conditions, we expect the net FAS, KAS pension adjustment to increase, become negative actually in 2009.

Secondly, we expect substantial improvement in shipbuilding margins.

Thirdly, we don't expect the same level of royalty income as we have seen in 2008 and for sales, we expect to see continued growth based on our new business awards and strong backlog that we've experienced on a year-to-date basis.

And finally, I would expect that the strong cash generation capability of the Company to continue into 2009.

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

Okay, thanks, Jim.

We're ready to go to Q&A please.

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Joe Nadol of JPMorgan.

Please proceed.

Thanks, good morning.

Good morning, Joe.

First question is on backlog and bookings.

It looks like some good performance.

The one area there that looks like it was down a little bit is space.

I was just wondering if you could comment on some of the things going on in space?

We've seen some delayed programs and that sort of thing.

Any color would be helpful.

This is Ron.

Space tends to come in lumps so it tends to be variable so in a given quarter, you may not see much.

Next quarter you may see a significant amount.

It's a small number of large programs.

I think that would probably be the way to explain it.

Right.

Just in terms of trends though I'm looking at the nine month number and big picture with TSAT looking like it's getting pushed out, any thoughts around big picture on the industry?

Obviously, TSAT will put some pressure on future growth in that area.

On the other hand we have a lot of other things cooking as well Joe so I'd say what you're seeing is basically the quarter to quarter fluctuations and awards.

Okay, and then secondly, on the LHD8, Wes, you mentioned there was a slight reversal of the reserve into profit.

Can you quantify that and can you give us a sense as to how much more opportunity there might be if you continue to hit these milestones?

Yes, Joe, we're making really good progress on LHD8.

We had a positive $34 million on the return to profit in the quarter because of the progress we've made to date.

At the same time though, we took a change in the booking rates, a more conservative approach looking across our full set of ship programs but essentially offset it, it was a little bit more, I think it was around $36 million, and so together, we viewed that as an appropriate way of looking at where we are in the programs.

LHD8 continues to perform well.

I wouldn't want to speculate on what the future might hold in that regard as we go forward because we still have some very important milestones to accomplish in front of us we're delineated in my remarks and on that slide but I am feeling better and better about how we're doing as continue to click these milestones off.

Okay, so the third just to be clear, the 36, how does that relate, the $16 million that you noted in your press release on the subcontractor disruption, that's exclusive of that so there's three independent items?

Three independent items, yes, Joe.

The hurricane impacts essentially Gustav was 16, Ike was 11, and then you have the LHD8 for --

Gustav was 11, Ike was 16.

Yes, I'm sorry.

Hurricane impacts were 27.

There you go.

And then you had LHD8 for a positive 34 and approach on essentially a risk assessment or more conservative risk assessment on the other programs of a minus 36.

Okay, and then on that note finally and I'll let someone else go, on that 36 what were the drivers of the adjustment there?

Was it more workforce stuff?

No.

It really is taking a more conservative view of the risk associated with the programs, looking at each of the individual contracts and the risk associated with completing them.

As you guys know, shipbuilding is characterized by programs or contracts that take many years to complete and so we just thought it was appropriate to be a little bit more conservative in our view about the risk of completing those programs.

Okay.

Thank you.

Thank you, Joe.

Your next question comes from the line of Myles Walton of Oppenheimer.

Please proceed.

Thanks, good morning.

Good morning, Myles.

So I want to talk about pension a little bit.

So first can you give us where the plan is as of today given the October market performance, can you give us a hand there?

Sure.

Let's see, Myles.

Easy to get for the end of September.

We were minus 12 at the end of September.

The market performance in October as you know has been poor.

Our estimate at this point would take that minus 12 to about a minus 20, maybe minus 21.

It's really, but it's hard to get those exact numbers because of for example, alternatives.

You don't value on a daily basis but it looks like kind of the minus 20 to minus 21.

Okay and then you mentioned a 20% break point which I guess you could go over.

What changes at that break point?

Essentially, at the break point, the KAS starts moving in concert with FAS, and so the net difference actually improves, the KAS actually moves greater than FAS after the breakpoint and so the net difference actually declines a little bit after that point and depending upon how far past we go by that breakpoint, cash contributions, required cash contributions would increase somewhat but probably in the couple hundred million dollar range.

Okay.

I think I got that.

And then lastly, on cash contributions what is your tax deductability limit for this year?

In the past you've obviously peaked out at about $1 billion in '06.

Is that kind of tax deductability limit?

I don't know what the limit is.

I don't know that we are effectively constrained in what we might want to put into the plan, but I don't know if there's a number that constrains us.

Okay.

Thanks.

Boring questions but thanks.

Thanks, Myles.

Your next question comes from the line of Robert Spingarn of Credit Suisse.

Perhaps a follow-on boring question, same topic.

Jim, if I understand correctly you just said 20, 21%.

Let's walk through what that means if that number holds until the end of the year.

That looks like that's an incremental $400 million?

Essentially if you follow those sensitivities that I outlined, that would be about $400 million if there's no change in the discount rate.

Okay.

And if there's no recovery in the investment performance, and as I said, we are in a very volatile market.

You guys know that.

If I look at our investment performance through August, we were at kind of minus 6%.

So the last 45 days have been really really volatile, and who knows what, I would be hopeful but I don't know what could happen the rest of the year.

Absolutely.

Okay.

And then sticking with accounting for a moment, could you walk through the royalty line and talk about what happened in electronic systems and where these reversals occurred, just so we can understand a little bit better?

Yes.

If you were to look at the income statement, essentially the royalty receipts are part of segment operating margin and so the segment operating margin rate or dollars in rate reflects the successful recovery or the settlement of those patent infringement areas.

We then reverse it in total margin and then add it back into other income.

So if you were to follow the income statement down, it's in segment, it's out of total, and then back into other income.

Okay.

That's helpful and finally, Ron or Wes, on tanker, termination fee.

Any update there?

No, Robert there is none.

We are currently awaiting for further instructions from the Air Force and also obviously awaiting for the next direction in terms of how the competition will be proceeding but at this moment we've not received any specific instructions.

Thank you.

Thanks, Rob.

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

Yes, good morning guys.

Hi, how are you?

In your outlook for 2009, Jim, you mentioned that we could see some kind of meaningful upside to the margins in the ship business.

What has to happen for that to happen?

Kind of maybe another way to ask it is outsiders looking in what do we need to see, what are milestones?

What can give us comfort that that can happen?

Ron?

It's simply performing against the contracts as we have today, the EACs on those contracts.

LHD8 for example, getting that ship completed is important.

Knock on wood, there may be some other opportunities like we had in the third quarter if we get through trials successfully and then on LPDs essentially the hurricane impact we think we have quantified that and have reflected that into our EACs, the opportunity essentially is to do better than what we've assumed in terms of helping our supplier recover from the impacts of the hurricane.

Obviously, we have a lot of experience in how to do that and so we've had a dedicated group of folks helping them with those kinds of issues as well as thinking about what work that maybe it makes sense for us to perform so that we can minimize the total impact of the hurricane Ike that the supplier experienced.

And if I could add, this is Ron.

Keep in mind that only about half of that business in ship building segment is down in the Gulf.

The other half is up at Newport News and part of this plan of course, is to continue to perform outstanding on our carriers and our submarines and that part of the business is going very well.

No, I mean, could we see an incremental like 50 or 100 basis points?

Is that a reasonable thing to try to model?

50 or 100 basis points to what?

Operating margin.

We're at 2.5%.

Well, I mean if you were to get, could you get towards 9% I guess is what I'm driving at?

Well, let's see.

As I said we will give guidance for 2009 in our fourth quarter call.

I really don't want to get ahead of that at this point.

I think as I said we're going to see a meaningful improvement in shipbuilding margin rates come 2009.

Okay, and then just one quick one for Ron.

You mentioned how Northrop's weathering the big financial storm.

From a much broader perspective, what impact do you think all of the government involvement in the capital market will have on defense spending, in terms of just crowding out?

The pie is only so big.

Ron, this is something we're spending a lot of time thinking about and I know you all are as well.

As I said in my initial comments, I would take it from the point of view that the threat spectrum out there is not going to probably get easier and so the Nation is going to have those threats.

The new President is going to have a whole bunch of issues to deal with but one of them he can't afford to allow happen is any real or perceived threat or attack on the Nation.

We are seeing an increasing willingness on the part of the Congress to allow deficits to rise.

That's obviously something a little bit different than we've seen in previous years.

We are seeing increasing momentum to potential tax changes or tax increases.

I think no matter who is elected we're looking for some of that I would think after stimulus is done.

We really don't know where it's going to be.

We know for '09 based upon the appropriated budget we're solid, we understand where the longer term contracts, we have multi-year contracts in some cases that are already under way.

Clearly the pressures are going to increase in the out years and I really don't know yet, Ron, how that's going to play but again, I keep coming back to the view that the threat is real.

It ain't going away and I think the key thing for us is to perform on the contracts that we have and make sure the contracts we're positioned on are the ones that are really going to be needed long term and that's where we're putting all of our energy.

We're very comfortable with our portfolio of where those contracts stand relative to what we think the needs are going to be and beyond that I think it's anybody's guess.

All right, thank you.

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

Good morning.

Good morning, Doug.

Good, good.

I'm interested on information and services.

Back in February, you talked about eventually long term getting to a 9% level margin, and as you look forward, and you look at the three units within information and services, how do you see that taking place over time?

Where do you expect the growth will be, where do you expect the margin improvement should come from?

Doug, as I think about that information and services I think that's an appropriate long term rate.

If I look at the three segments or three pieces, I would have mission systems at the highest level in terms of operating margin rate, the IT business essentially middle, and then the technical services business at the lower end below the average for the group in terms of margin rate.

In terms of improvement, I think the biggest opportunity is in the Information technology piece of the business.

But over time, if you have more growth in technical services, I'm just wondering about business mix here, as you lay out the different margins in those three units, if you have more growth obviously in technical services that's going to limit your margin upside.

Yes, I don't think so.

I think we are going to have proportionally or percentage-wise greater growth or have the opportunity to have greater growth in technical services but it is still a small piece of the total and so it doesn't drive the margin, or overall margin rate that greatly.

So again, when I look at both mission systems and IT, I see the potential for equal to or greater growth rate in terms of revenue in those two pieces as I do in technical services so I think the contribution, the relative contribution weighting will continue to be about what it is today.

Okay, and then on, then within there, Wes commented earlier that you're seeing size of the state and local backlog go down in IT but you did, you just did two small contracts with the State of Oklahoma and the State of Texas.

Are you thinking differently now about how you pursue those state and local contracts?

Yes, Doug.

It's Wes.

We are.

We're being very selective and we're looking at a variety of both financial criteria associated with the bid as well as I'm better understanding I think the customer expectations and their ability to contract in a way that makes sense for us, so we have introduced a number of parameters that we're assessing in the state and local environment.

So you haven't ruled them out.

You're just looking at them differently?

Yes, no, we have not ruled them out.

There are some meaningful opportunities there but we are being I would say substantially more selective today than we were even a year, year and a half ago.

Yes, Doug, we have actually passed on a couple of fairly substantial opportunities that under previous circumstance, we might have well thought we couldn't resist, and we basically no bid them.

Okay, great.

Well, thank you.

Thank you.

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

Good morning, David.

Your pension asset allocation, you made the comment that it's shipped away from equities.

I think we had you close at 50% based on your 10-K and the move to down 21 or 22% during October seems to indicate still pretty heavy weighting towards equities.

Do you have an updated allocation that you could provide?

Yes, in terms of benchmark, our policy, we at the end of last year had a 55% weighting to equities, the new benchmark is 35% and at the end of September, we were a little bit over 25% in equities.

Okay, and what about fixed income versus other?

Essentially, the move in the benchmark or the policy from 55 to 35, we took 10 percentage points and added it to alternatives and 10 percentage points and added it to fixed income.

So from a policy perspective today it's 35% equities divide it between domestic and international, 25% in alternatives and 40% in fixed income.

Okay.

And Ron, could you spend a second and maybe talk about how Northrop is looking at the smaller satellite opportunity, what I guess is referred to as ORS, and what exactly the Company is doing in that area?

Well, obviously this is something we have continued to track in.

We have not been a major supplier of small satellites over the years, David.

Revenues have not been the same as they've been for some of our larger satellites.

We do look at some of these satellites.

We do look at ways that we can take off the shelf payloads, put them together.

We have a couple things we're thinking about now.

I don't think we're in a position to reject any significant targets or awards in that area at the moment but it is something we will see continuing.

There's been, in my experience in this satellite business and it spans four decades sorry to say, there's always been almost a dichotomy of view between large efficient satellites and small cheaper, faster, better satellites.

It goes back and forth in cycles and it usually goes with what the most recent failure and shortcoming was.

Today, we're seeing some significant concerns about large satellite programs.

I think the dog group in the Pentagon deciding not to proceed at the moment with TSAT, part of that issue has to do with the mission requirements and part of it has to do with the concern about how large it is.

On the other hand in other venues in military and intelligence world, you do see large satellite programs.

So I think we're going to see a mix over time.

I think the preponderance of revenues is still with the larger satellite programs and those are the franchise programs.

That's great and one last one maybe for Wes.

The green labor situation that was so much a problem on LHD8 can you kind of address where you are there?

Yes, it continues to improve.

We've instituted a number of activities in the Gulf to address training.

There's been a lot of the application of lessons learned on LHD8 to the other activities we have under way in the Gulf.

We continue to look for experienced new hires but I would say overall our labor situation in the Gulf has stabilized and we feel very good about the quality of the capability of the labor force there.

Great.

Thanks guys.

Thank you, David.

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

Good morning.

Nice quarter guys.

Thank you, Heidi.

Ron, I want to ask you a little bit about the outlook in 2009.

Both candidates have been talking about it looks like in the next administration both sides are going to take a focus on cost growth within defense programs.

Can you give us a sense about what steps you're taking to mitigate cost growth ahead of time so that when they turn to you and do an in depth review you come out strong?

That's an important question, and it's a broad one.

Obviously, for as long as I've been in the business and I think everyone else, procurement reform, cost growth have been the fundamental issues.

It's just been the nature of the business of buying large weapon systems.

I think both candidates are going to take a fresh look at it.

A lot will depend upon who they put in place in their national security teams and defense teams.

We do believe that there might be some initial pressure toward changing contracting types but the thing with changing contracting types is that's on a go forward basis.

I think what we would have to do Heidi is be prepared to bid the programs appropriately for the contract type that's required.

So for example, there's more pressure on fixed price contracting.

I think speaking for Northrop, we're going to be much more careful in terms of how we would approach that from a risk management standpoint.

I would dare say most of the other companies would be as well.

We've all been through the cycle about 15, 20 years ago where those enormous pressure to do that and that did not work out well either for the industry or frankly for the Pentagon because a lot of programs got cancelled.

One of the things we're doing internally and one of the things that Wes is focusing on very very intensely is the execution of the programs we have, making sure that we're driving on technical performance, scheduled performance and working to achieve the potential of the margins that are available to us on those programs as we negotiate the contracts and then going forward of course as we mentioned a couple of times in the call, we're taking a much more careful look at the structure of the contracts going forward.

Bad contracts can beat good people 9 times out of 10.

We want good contracts.

Great.

Thanks, that's very helpful.

And secondly as a follow-up, can you flush out a little bit how does 2009 sales look if we do see a material step down in new program awards just again because of this budget tightness and we're already seeing with ARH and TSAT and others?

Well, Heidi, first of all the way our business works as you know with our record backlog, that really does define a good portion, an enormous portion of the estimated sales revenues for next year.

Secondly, the majority of that is actually funded as a result of the Defense Appropriate Bill for 2009, and so as Jim had indicated in his, at the end offer his remarks we did see growth in 2009 and we'll quantify that obviously in the fourth quarter call.

So at this point in time, if I take a look at our portfolio of programs, there are always potential programs that could be cancelled mid year.

We don't see a lot of that at the moment, and frankly, the programs that were involved were pretty well fully funded as part of the '09 budget.

I do know that Ron, which is why I was hoping you might give us a percentage so that we could again know how much of your revenues ahead are sort of rock solid.

Is it fair to say 80 to 90%?

Heidi, I'd say that's about right, maybe as much as 90%.

Rock solid, you hate to say that word because you never know what will happen but historically very very solid funded, backlog, funded programs, budgeted for the fiscal year and I would say certainly in the high 80's perhaps as much as 90%.

Thanks very much.

Thank you, Heidi.

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

Please proceed.

Thank you.

Good quarter.

Thanks.

Could we return to shipbuilding?

You mentioned $27 million of kind of charges for Ike and Gustav, $34 million plus and the $36 million risk adjusted.

Is the 27 included in the 36 or are those separate so that is the net impact $29 million negative?

The net impact is the 29 number.

Okay.

And then if it is the 29 number, if we added back and I understand It's not totally right because some of the risk mitigation reflected current period, that would imply a margin in shipbuilding of about 10%.

Was there anything else positive in there to get us to that kind of a number or was a lot of this risk mitigation applicable to the current period revenues?

Well, you did pretty good math, Cai, and yes, if you make those kind of adjustments you would get to that kind of number.

There obviously were some strong performance in other programs as well, none of which I would characterize as unusual or exceedingly large, if they were, we would have talked about it, so there were some programs in shipbuilding that had good, strong performance in the quarter.

And it goes with the comments that Ron and Wes have made about our attention to shipbuilding and the focus we all have is on how do we improve the Gulf Coast but there is parts of the shipbuilding enterprise that is doing very very well.

Okay.

And then if we could kind of return to pension, you kind of mentioned that it's basically $4 million for each 1 point in performance.

Let me make sure we got the numbers right.

For every 100 basis points change in the investment return, pension expense would increase or decrease by 40, 4-0 million.

I guess the question is, is that linear or, if in fact you're at 20 million or $21 million under water, do you basically go outside of the corridor so that number begins to escalate?

No.

Not true.

For financial accounting, for FAS, it is essentially linear after our 10%, negative 10% assumption so the FAS number is essentially linear, that 100 basis points is $40 million, after the breakpoint, then KAS starts moving in concert, actually moving greater than FAS and so the net difference above the breakpoint starts coming down.

Oh, okay.

That's very helpful and then assuming you are in fact at 20 to 21% under water which as we close the books likes like we'll be there or greater, what are your initial thoughts about how much you might contribute to the pension plan either in the fourth quarter or next year?

How do you think about how you approach that problem?

Well, we start with cash, the strong cash flow of the Company and we think about where the actual returns may come out and where the discount rate may come out, all of which will be factors or considerations as we think about how much we may want to put in from a voluntary perspective into the plan here in the fourth quarter or maybe even early in 2009.

The last one on pensions, you mentioned a year-over-year swing of $415 million from 165 plus to 250 minus and yet if FAS goes to -- if -- that would imply that FAS goes to 665 implying that KAS has to go down to around 415 to 450 is that in fact what you're actually saying if you close?

I think you may have the numbers backwards.

Today, 2008 we have essentially a net FAS/KAS income of $250 million.

Correct.

At 10%, minus 10 and 7, it goes to an expense of about $165 million.

That's the 415, the net change.

And that 415 is essentially FAS going up by 465 and KAS going up by 50 to get to that 415 net.

I've got it.

Thank you.

I guess the other thing I think you all recognized but I feel like I have to mention it, as you know, we use the actual market value, our plant assets at the end of the year for determining our pension expense for next year.

Others have a smooth effect.

Economically, the results are exactly the same.

It's only the timing of when you recognize those economic results.

We are recognizing them currently.

Others are deferring them into future years.

My estimate is that if we were using a method similar to others that 415 change year-over-year, about 75% of it would have been deferred.

Excellent.

Thank you very much.

Thanks, Cai.

Your final question comes from the line of Carter Copeland of Barclays Capital.

Hi, Carter, how are you?

I'm good, guys.

Actually, all of my questions have been answered.

Thanks, good quarter.

Thank you.

We like those calls.

And there are no further questions at this time, I'd like to turn the call back to Mr.

Gaston Kent for closing remarks.

Okay, this is Ron.

This closes the call, and I want to thank everybody for attending, strong quarter.

We really appreciate your continued interest and we look forward to talking to you at the end of the fourth quarter call.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Good day.