諾斯洛普·格拉曼 (NOC) 2012 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 Shannell and I will be your operator for today.

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

Later, we will conduct a question-and-answer session.

(Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to Mr. Steve Movius, Vice President Investor Relations.

Please proceed.

Thanks Shannell, and welcome to Northrop Grumman's Second Quarter 2012 Conference Call.

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

Before we start, please understand that matters discussed on today's call constitute forward-looking statements pursuant to Safe Harbor provisions of Federal Securities laws.

Forward-looking statements involve risks and uncertainties, which are detailed in today's press release and our SEC filings.

These risk factors may cause actual Company results to differ materially.

On the call today, are our Chairman and CEO, Wes Bush, and our CFO, Jim Palmer.

Please go to slide 3. At this time, I'd like to turn the call over to Wes.

All right, thanks Steve.

Good morning, everyone.

Thanks for joining us on our second quarter conference call.

This was an outstanding quarter in a challenging environment.

Segment operating margin rate, EPS, cash from operations, and free cash flow all improved over last year.

And new business awards totaled $8.8 billion, a book to bill of 140%, which increased our backlog to $41.5 billion.

Our focus on superior program performance, cost reductions, and customer affordability in combination with effective cash deployment continues to generate solid financial results and create shareholder value.

All four of our businesses performed well.

Together, they generated segment operating income roughly equal to last year's second quarter despite lower sales.

And segment operating margin rate increased 50 basis points to 12.5%.

Earnings per share increased 4% to $1.88, and on a pension adjusted basis earnings per share increased 13%.

Cash was also a highlight for the quarter.

Cash from operations totaled $876 million, and after capital expenditures of $51 million, we generated free cash flow of $825 million.

During the quarter, we continued to execute our balanced cash deployment strategy.

In the second quarter, we repurchased 4.9 million shares of common stock for approximately $295 million.

Year to date repurchases totaled 9.3 million shares for approximately $560 million.

We also announced a 10% increase in our quarterly dividend in the second quarter.

Maintaining a competitive dividend payout ratio, on a pension adjusted basis, continues to be a priority in our cash deployment strategy.

Year to date we've returned $820 million to our shareholders through share repurchases and dividends, which is consistent with our pattern of returning more than 100% of free cash flow to our shareholders over the last several years.

Turning to guidance, based on our year-to-date results, we're increasing 2012 earnings per share guidance to a range of $7.05 to $7.25, from the prior range of $6.70 to $6.95.

Our sales guidance for the year is unchanged.

2012 guidance assumes a continuing resolution in the fourth quarter, but our guidance does not contemplate extraordinary customer actions in anticipation of a potential sequestration at the beginning of 2013.

We continue to see modest organic sales growth in key domain areas, which is being offset by our portfolio shaping actions and lower volume for other programs due to ramp-downs and cancellations.

We continue to capture new business in our key focus areas of C4ISR, unmanned, cyber, and logistics and modernization, based on our competitive discriminators in these areas.

Our $8.8 billion in new awards included several large awards in our strategic focus areas.

These include $1.6 billion for NATO AGS, as well as multi million dollar contracts for the next-generation Fire Scout unmanned helicopters, F-16 Airborne Fire Control Radars for Thailand, Iraq, and Oman, cyber security projects, and a contract to upgrade the US Air Force's electronic attack pods.

We also recorded $1.4 billion in awards for the James Webb Space Telescope.

This quarter's awards resulted in a 6% increase in our total backlog.

So overall, it was a very good quarter.

But as we look ahead, we see an increasing risk profile due to budget uncertainty.

This uncertainty becomes more critical as we progress through the year, and we recognize that it's also a major area of concern for all of our stakeholders.

As the government formulates future defense budgets, we are preparing for various potential scenarios, including sequestration.

Like others in our industry, we are very concerned about sequestration's serious negative consequences for national security and the defense industrial base and the shareholders, customers, employees, suppliers, and all the communities that rely on the defense industrial base.

While we've not received planning guidance from the government on how sequestration would be implemented, we are developing contingency plans.

There are many variables in how the law could be implemented that will determine the specific impacts.

However, we expect as it is currently provided for under the Budget Control Act, sequestration would result in lower revenues, profits, and cash flows for our Company.

We appreciate the work that some in Congress are undertaking to ensure the capability and readiness of our nation's military under the specter of a potential sequestration.

We believe that a solution that avoids sequestration and its destructive impact is in our best national interest.

In addition to sequestration, we're also planning for various other budget scenarios.

All of which call for a heightened focus on innovation, cost reductions, and customer affordability initiatives.

Over the last several years, we've improved our performance for shareholders and customers by driving program performance, reducing costs, and enhancing our portfolio alignment.

Our year-to-date results demonstrate the positive impact these actions are having on our existing portfolio of contracts.

They also position us to compete in a more challenging environment.

We believe that we're taking the right steps in the current environment and that we can continue to create value for our shareholders by remaining focused on our key priorities.

Performance, effective cash deployment, and portfolio optimization.

Now before I turn the call over to Jim, I want to provide some perspective on Monday's leadership succession analysis.

These organizational changes take effect in 2013, and are the result of thoughtful and thorough succession planning as well as extensive internal leadership development.

We decided to announce these changes now in order to enable a seamless leadership transition over the next five months.

At Aerospace and Electronics, Gary Ervin and Jim Pitts each informed me of their intention to retire, Jim at the end of this year, and Gary in the first quarter of next year.

Both Gary and Jim are outstanding leaders whose contributions to Northrop Grumman, our industry, and our nation's security are too numerous to name here.

I want to personally thank Gary and Jim for their support and their leadership over these past several years.

They have been instrumental in achieving the superior program performance and affordability improvements demonstrated in our financial results.

Linda Mills, the President of Information Systems, will join the corporate office as Corporate Vice President for Operations.

Linda has done an outstanding job at Information Systems, both in shaping our portfolio and in improving financial performance.

In her new role, she will focus on our operational efforts that we have underway across the Company to support our drive for sustained performance, even as our environment becomes more challenging.

Gary, Jim, and Linda will continue to lead their organizations through the end of the year, which will support a smooth transition for our incoming sector leadership, all of whom are current Northrop Grumman leaders.

Tom Vice, the current President of Technical Services will become President of Aerospace Systems.

Tom joined what is now Northrop Grumman's Aerospace Sector in 1986 as an engineer on the B-2 program.

He's held a variety of AS leadership positions of increasing responsibility in operations and program management as well as business development.

Before assuming the TS Presidency, Tom led the Aerospace Systems Battle Management and Engagement Systems Division, which encompassed the E2, LEMV, and BAMS programs.

And he also served as Vice President for Navy Airborne Early Warning and Battle Management Command and Control Programs.

Gloria Flach, current President of Enterprise Shared Services, will become President of Electronic Systems.

Gloria joined our electronics business in 1981 and held numerous positions of increasing technical and management responsibility before leading our shared services organization.

Just before assuming her current role at ES, Gloria was Vice President and General Manager of the ES Targeting Systems division, and she also served as the Vice President and General Manager of the Engineering and Logistics for Electronic Systems, which included executive responsibility for Engineering and Manufacturing Operations and Logistics Services across the ES sector.

Linda, Tom, and Gloria are current members of Northrop Grumman's Corporate Policy Council, which is our senior leadership team, and as such they will provide additional continuity to the management of the Company in their new roles.

Kathy Warden will become President of Information Systems.

Kathy currently leads Iinformation Systems' Cyber Intelligence Division, which provides cyber capabilities to national and military intelligence programs.

Kathy joined Northrop Grumman in 2008 as Vice President, Strategic Initiatives, where she was responsible for ISR market strategies, including key growth campaigns in cyber and intelligence information sharing.

Kathy joined Northrop Grumman after having worked at another defense company, as well as having worked in the commercial sector.

Her breadth of experience is well aligned with the breadth of market focus at IS.

With the transition of Tom Vice to Aerospace Systems, Chris Jones will lead Technical Services.

Chris currently leads the integrated logistics and modernization division at TS.

Chris joined Northrop Grumman in 2004 as the Director of Product Support and International Programs for the Airborne Early Warning Program at AS.

He managed personnel located in several US states and countries, and was responsible for all domestic E-2 Hawkeye support and international E-2 programs.

In addition to his program execution responsibility, he also was a key member of the Business Strategy Development and Capture teams.

In addition to these changes in our sector leadership, Mark Caylor, our Treasurer will assume the Presidency of Enterprise Shared Services.

And Prabu Natarajan, Vice President of Tax, will continue with those responsibilities and also take on Treasurer responsibilities.

Dave Perry, whose appointment is effective immediately, will become Corporate Vice President and Chief Global Business Development Officer.

Dave previously served as Vice President and General Manager of the Naval and Marine Systems Division in Electronic Systems.

Each of the individuals chosen to lead our businesses has broad and deep industry experience and superior expertise and domain knowledge in their business areas.

One of Northrop Grumman's strengths is our leadership bench, and we are fortunate to have such talented leaders within Northrop Grumman to take on these roles.

All of these individuals have been important contributors to the operational performance improvement we've achieved over the last several years.

And I'm looking forward to accomplishing even more as we move ahead next year.

So now I'll turn the call over to Jim for a more detailed discussion of results and guidance.

Jim?

Thanks Wes, and good morning ladies and gentlemen.

The highlights for the quarter were the strong new business awards and our 12.5% segment operating margin rate, which combined with share repurchases generated a 13% increase in pension adjusted earnings per share.

On a pension adjusted basis operating income was comparable to last year's second quarter, and pension adjusted operating margin rate increased 50 basis points to 11.8%.

Operating income for the quarter included a $64 million reduction in the net FAS/CAS pension adjustment.

Our improved results reflect in part the aggressive cost reductions we've taken to improve our affordability in anticipation of likely budget declines.

We are realizing the benefit of those cost reductions on our existing backlog of contracts.

Based on our year-to-date performance, we now expect a 2012 segment operating margin rate in the high 11% range with a total operating margin rate in the mid 11% range.

Our effective tax rate for the quarter was equal to last year's at 34%, and we continue to expect an effective tax rate of 33.75% percent for the year.

We do not assume an extension of the R&D tax credit in that guidance for tax rate.

As Wes mentioned, cash results for the quarter were outstanding, and reflect lower retirement benefit funding as well as lower working capital requirements than in the prior year period.

Our team's efforts to accelerate cash flow within the year are yielding benefits.

However, we still expect cash flow to be weighted towards the second half of the year as is our typical pattern.

Guidance for cash from operations is unchanged at $2.3 billion to $2.6 billion, and we continue to expect free cash flow to range from $1.8 billion to $2.1 billion.

Turning to the sectors, sales in Aerospace Systems declined by $69 million, or 3%.

Adoption of the units of delivery revenue recognition method for the F-35 LRIP 5 contract impacted sales by approximately $30 million this quarter.

The loss of the DWSS sales due to its cancellation last year also impacted year over year sales by about $56 million.

F-18 volume was lower due to two fewer deliveries this year, and B-2 volume declined reflecting reduced modernization efforts on that platform.

Lower volume for each of these programs more than offset the higher sales in the E2D program and our unmanned programs.

Aerospace operating income declined by 9%, and resulted in an operating margin rate of 12.1% compared with 12.9% last year.

The two major drivers of these changes are the transition to the lower margin multi-year three contract for the F/A 18 and the absence of last year's favorable NPOESS performance adjustment.

For the year, we continue to expect AS sales to range between $9.7 billion and $10 billion, with a mid-11% margin rate for the year.

AS awards totaled $5.1 billion this quarter, which brings their total backlog up to nearly $21 billion.

In Electronic Systems, sales declined by $47 million or 3%, reflecting the de-emphasis of our domestic postal automation business, which reduced sales by $34 million.

We also experienced lower volume for international postal automation, laser systems and infrared countermeasures.

Declines in these areas were partially offset by higher volume in our space business.

ES operating income declined by 3%, consistent with sales, and the margin rate for the quarter was comparable to last year at 15.8%.

For the year, we continue to expect ES revenues of $6.9 billion to $7.2 billion, but we are increasing our ES margin rate guidance from mid-14% to low to mid 15%.

This guidance reflects a margin rate of approximately 14% for the second half of the year, roughly in line with our original ES guidance for the year.

At information Systems, sales declined by $175 million, or approximately 9%, on a year over year basis.

The cancellation of the JTRS AMF program as well as the wind down of the F-22 and last year's sale of the County of San Diego IT Outsourcing Contract together impacted sales by approximately $75 million.

The balance of the sales decline reflects the general market softening due to the uncertainty of the budget environment and the shorter cycle nature of our IS business.

Despite the lower sales, Information Systems operating income increased by 7% and operating and margin rate expanded 160 basis points to 10.9%.

Favorable performance on civil systems programs more than offset the impact of the lower volume.

For the year, we continue to expect IS sales of $7.4 billion to $7.6 billion, although based on our year-to-date results, I think 2012 sales will likely trend towards the lower end of that range.

And we now expect a 2012 operating margin rate at IS of approximately 10%, which is an increase from our prior guidance of mid-9%.

Turning to Technical Services, second quarter sales increased slightly during the quarter due to higher volume for integrated logistics and modernization programs.

This more than offset the impact of portfolio shaping actions and lower ICBM volume.

Operating margin rate expanded 150 basis points to 9.5%, principally due to a favorable performance adjustment for risk mitigation on a Department of Homeland Security contract.

For the year, we now expect TS sales of approximately $2.8 billion to $2.9 billion, with a mid-8% operating margin rate.

So, on a consolidated basis, our 2012 sales guidance remains unchanged at $24.7 billion to $25.4 billion.

But based on the first half results, we are increasing our guidance for segment operating margin rate to high 11% from mid-11% and total operating margin rate has increased to mid-11% from low 11%.

We now expect our share repurchases to reduce our annual weighted average share count by approximately 10% versus the prior assumption of 9%, and as will be disclosed in our 10Q filing, second quarter net cum catch up adjustments were $222 million, which is an increase of $21 million from the prior year.

The improvement reflects a slightly higher level of positive adjustments as well as a slightly lower level of negative adjustments than in the prior year.

The improvement is a result of our risk management process, and affordability initiatives.

Individually, none of the contract adjustments were material.

Before we begin the Q&A session, I just thought I'd take a few moments and talk about the impact of the Pension Relief legislation that was recently passed in the highway bill.

As many of you may know the legislation impacts the timing of mandatory pension contributions.

Our analysis indicates that our mandatory contributions will decrease over the next three years and then those deferred contributions are paid back over the following five to six years.

We estimate that the law reduces our otherwise required cumulative contributions for the years 2013 through 2016 by approximately $1.5 billion on a pretax basis or about $900 million on an after-tax basis.

The change in law does not impact 2012 required contributions of $65 million.

Now, we'll want to maintain the financial health of our benefit plans.

We view it as a competitive advantage for us.

So depending upon investment performance and our tax planning strategies, we may elect to use some of this additional future cash flow provided by the legislation to voluntarily fund our plans.

So in closing, our second quarter results demonstrate just outstanding operational performance.

We remain focused on generating shareholder value through performance improvement, effective cash deployment, and portfolio optimization.

So Steve, I think with that introduction we're ready for some Q&A.

Thanks, Jim.

Shannel, we are ready to begin the Q&A process.

Thank you.

(Operator Instructions) We do ask that all participants in the queue please just ask one question.

Sam Pearlstein of Wells Fargo.

Good morning.

In the past, you had said there would be about a $500 million impact this year from the combined impact of the change on the F-35 and portfolio shaping.

Can you just talk a little bit about that?

I'm trying to just understand at what point do I look at your revenue year-over-year and say -- this is what the organic trend is versus the portfolio shaping.

When do we anniversary all that, and do you still feel comfortable that $500 million is that right number for this year?

I'm trying to remember.

I don't think the F-35 alone, that transition to units of delivery accounting, was $500 million.

I think it's more like $200 million.

And essentially the revenue will start reversing here in second half of the year as we begin deliveries on LRIP 5. The balance was portfolio shaping and other actions.

But the F-35 itself, units of delivery was $200 million impact on 2012.

Carter Copeland, Barclays.

Wes, I'm interested in your comments around sequestration, and the various scenarios you're planning for.

I wondered if you might speak to some of the differences in those scenarios?

What some of the key factors are that you are looking at and judging the potential severity of some of these impacts?

Any color would be helpful.

Yes, we're in a -- just a fascinating situation here today.

We have this law on the books that mandates that sequestration will occur on January 2. So, that's the law.

And I want to be clear that we will be ready to address that environment, should that occur.

But as I said in my remarks, that environment would represent lower revenues, profits, and cash flows for our Company.

That said, we also know that the President and the Secretary of Defense, and to a very large extent, the leaders of both parties in congress have said they do not want sequestration to occur.

So, exactly how this is going to play out is anybody's guess right now.

And there are a lot of different scenarios floating around, and everybody has their own view as to what might happen and when such things might happen.

What we're doing is making sure that we're ready, and that means both planning for a variety of scenarios, both the sequestration scenario itself, as well as other scenarios that might involve potential compromise positions on the part of the different parties that are taking part in this debate.

We're doing that so that we're ready for a variety of outcomes.

And we're doing it mindful that as we are making those plans, and actually taking steps today to make sure that we're ready, we're doing that while ensuring that we're continuing to meet our customers' needs.

And keeping all of that balanced as we go through here is going to be very, very important.

The other part of this that's also very, very important is making sure that we're doing the right things to have a very talented and capable workforce for the future.

And we're mindful of all of those dynamics as we are planning our actions, as well as taking some actions today to preserve our flexibility and to make sure we're ready to really take this on however it goes.

One thing I would point out though is we see some constants in here.

And I think those constants, while we're all concerned about the coming months this year, looking past that at the longer term is really important.

And one of the big constants that we see goes to the way that we've aligned our portfolio.

We believe in just about any scenario there's going to be a continuing priority for unmanned capability, cyber capability, and C4ISR.

And this whole arena of modernization and its focus through logistics, I see that too as being an important part of our portfolio for the future.

So, when we think about what's going on in the world, when we think about the environment that our national security customers are having to deal with, that part, I think, is a very important perspective as well.

Trying to determine which exact path we're going to take to get to that longer term state is a little bit of a challenge.

But we're going to be ready for it.

Howard Rubel, Jefferies.

Good morning, gentlemen.

Thank you.

You have pretty darn good information systems margins, and Wes, I know you've worked very hard to have that portfolio, I'll call it, realigned, changed, and you've sort of solved a number of problems there.

Can you say that you've fundamentally changed it in a way that maybe your profit expectations for the business unit are higher?

Well, I would say that what we've done is we've changed it in a way to support the profit expectations we've put out there.

If you turn the clock back a number of years ago, we had a fairly large fraction of that portfolio that was in what I would describe as more commodity services business.

And today if you look at the portfolio, and I have to give Linda Mills and her team the credit for this, they've just done an extraordinary job of managing their way through the portfolio alignment here.

It has a very large part of the content that is C4ISR and cyber, and if you look at the parts of the portfolio that are more service oriented, those typically have significant engineering content.

So, we're bringing value-added, and it's not a competition that's solely on the last penny.

It really is around bringing the value of the engineering content.

So, those actions have given us the confidence to talk about the margin rates that we put out there for this business, as being the appropriate margin rates for the longer term, just given the broader character of how we've repositioned this business.

It just seems to me that when we think about a government services business, this is really not that.

It's something different, and it fundamentally offers different value.

I agree, Howard, very much so.

This does not any longer fit that model of a traditional government services business.

And as you know very well, we actually spun out our -- or sold off, I should say, the primary part of that business that we used to have, the TASC organization.

And that was a big part of this portfolio realignment was to take that out and put it into a different construct, so it's no longer a part of our portfolio.

Thank you.

Thanks, Howard.

Doug Harned, Sanford Bernstein.

Good morning.

I was interested, and Jim and Wes, you've talked about the cost reduction efforts you've had, and how that's contributed positively to margins.

When you look forward, the margins have been very, very strong in the first two quarters of this year, particularly in electronics.

Now, as you look forward, is there -- not that this is necessarily the normal margins, but is there more to come in terms of ability to get margin expansion through these initiatives?

Or is this all, I would say, managing to a point where you're expecting some weakness later, and we'll see margins revert back to a lower level?

Doug, as I think about it, we clearly have gotten some benefit from the actions that we've taken over the last few years, not just last year, but over the last few years.

It's really been a concentrated effort, beginning, going back to 2009, when we combined what was at that time six different businesses, down to the four businesses.

And in that process, we made some really significant improvements in our basic infrastructure costs.

For example, if I use 2008 as a benchmark, 2011 revenues were up 1% over 2008.

Square footage, on the other hand, was down 6%, and the infrastructure that goes with the business, largely people related, was down 11%.

So, in a continual process to think about the business, the organization that supports it, the infrastructure that's required, you get the benefits of that on your current backlog of contracts.

But it's very important that you do those things because it goes to the affordability of your products.

And in a likely down scenario in the budget, affordability is a key driver on being able to compete and effectively win.

So, we've gotten the benefit.

At the same time, we have really emphasized the management of our individual contracts, identifying risks and opportunities, and our program management organization, I think, has done a really good job over that period of time, and is in a better position today than they have been in the past.

It's a combination of all those factors that I think lead to the improved performance that we've seen.

And when you look forward, do you continue to see some ability to improve on the margin side?

Well, clearly that's what we incentivize our people to do, and so, we are driving towards that.

You may be asking about the long-term objectives, margin rates for the businesses.

I continue to believe in those -- that those are the long-term margin rates that are sustainable through the cycle.

Clearly, we want to do better than those kind of peer average type margin rates, and we're working very hard to do that.

It's interesting that we normally get a lot of questions around cum catch-up adjustments.

And having spent a lot of time with those over the last five or six quarters, many times those items relate to either contractual issues or maybe some testing issues associated with individual contracts, which largely are not resolved until the contracts are fairly well complete.

And at that point in time, you feel comfortable in making those adjustments and recognizing them.

But having completed or largely completed these contracts does not necessarily imply that those will be the margin rates on a go-forward basis.

I guess a long-winded way of saying I feel comfortable about our guidance for the year, obviously, as well as our long-term margin objectives for the Company, and we will clearly work to do better than that.

Okay, thank you.

Thanks, Doug.

Jason Gursky of Citi.

Good afternoon.

Jim, I've got just a quick question following up on a statement that you made earlier about the competitive positioning of Northrop relative to competitors, given your pension position.

The question is two-fold.

One, I know that starting on February 27 of this year, yourselves as well as some of your competitors were able to begin booking higher rates, higher billable rates in to the government.

So, I just wanted to get a sense of what type of activity you're seeing on that front, and success or lack of success in being able to do that.

And then the second part of the question is -- where do you think this is going to have the most impact as you look at your various businesses?

Is it weighted towards services, where you get the competitive advantage, or is it electronic systems?

If you could just give us a sense of where you think this competitive advantage is going to have the biggest impact, I'd appreciate that.

You're referring to the CAS Harmonization, Jason, just to make sure everyone is up to speed on that.

And CAS Harmonization actually serves to increase everyone's CAS costs, everyone in the industry's CAS costs in relation to what they had previously.

So, it is a factor that allows us to recover those increased costs, but it does also drive to the competitive nature of the affordability of our costs.

It's great that we're able to recover those increased CAS costs, but it is an affordability negative.

And so, we are working real hard to offset that.

In terms of the competitive nature, obviously to the extent that your plans are better funded than industry as a whole, your costs are less on a go-forward basis.

And so, that is something that, as I've said, we've worked really hard to try to address over the past years, through our investment performance, which has been positive.

I think our investment management organization has done a really good job in relationship to the uncertain investment environment that we've had over the last three or four years.

It's certainly been a difficult environment, but they've done very well in terms of performance versus the major indices, all of which, again, goes to reducing our costs on a go-forward basis.

It's a combination of all of those factors, Jason, that I think is a competitive advantage for us on a go-forward basis.

Although, as I said, it's great to recover that increased CAS cost, but it does become a negative that we're working hard to try to offset.

Which business do you think it's going to have the most impact on for you?

It's really going to depend on individual plans.

We talk as if this is a one, huge plan, when in reality we have about 20 different plans -- so, it depends on the funded status of each plan.

But the area that we're most focused on has been the Aerospace segment, largely because the plans that support that have historically been very well funded, and for many years did not have any CAS costs at all.

So, we're dealing with that in our Aerospace segment largely.

Okay.

But it does affect some of the other segments as well, in both ES and IS.

Great.

Thank you.

Cai von Rumohr, Cowen and Company.

Yes, thank you very much.

So, Jim, could you update us a little bit, thinking about pension for next year.

First, -- just two general questions.

What's your investment performance year-to-date?

And secondly, given that discount rates are down today from where they were at year-end, and I know it only depends on where you close out the year, what sort of leverage does that have?

And I know you have kind of your own indices.

How should we think about the change in discount rates, and what that might mean for next year's FAS costs?

Yes, so, Cai, the investment performance through June is, round numbers, let's call it 5.75%.

So again, the organization has done a good job relative to the indices.

They always tell me I can't annualize that number, so I won't do that -- but reasonable performance on a year-to-date basis.

And as you know, I think everyone knows, interest rates are down from where they were at the beginning of the year.

We're probably looking at, if we were setting interest rates today, anywhere from maybe 75 to 100 basis points of decline.

And just a reminder that the sensitivity around that change in discount rate is that for every 25 basis points change in the discount rate, let's call it, $75 million to $80 million of change in FAS costs.

So, if we were setting the discount rate today, we would be looking at a decline in interest rates, let's call it, 75 to 100 basis points, and that equates at this point to, if I can do my math here real quick, $300 million FAS increase.

Okay, terrific.

Thank you very much.

But again, it's kind of meaningless to talk about it at this point in time--

Absolutely.

Joe Nadol, JPMorgan.

Thanks.

Good afternoon, guys.

I was hoping to drill down just a little bit into ES.

Margin performance, of course, at the Company has been great.

It's been, I think, particularly strong here though.

You have the five business areas you've laid out within ES.

And I was hoping maybe either Wes or Jim, you wouldn't mind walking through the business a little bit, and telling us where the margins, relative to the segment average, are above or below in each of those five units.

And just maybe helping us understand a little bit the complexion, the profile of the segment.

Joe, I'm not going to do that, because I don't want to give out competitive information here.

The performance in ES has been strong in a couple of areas in particular.

But having said that, that doesn't mean that the performance in the other areas is weak.

They're performing, if you will, as expected, but performance in a couple of areas has been particularly strong.

Maybe what I could ask then on that, if it's been a couple of areas in particular, you must have visibility on how much of that is sustainable.

So, as we look forward and we think about -- and we know your long-term margin target for the segment, but how much more opportunity is there for performance adjustments in those couple of areas that have been really strong?

As I said in my prepared comments, Joe, the guidance for the year for ES essentially assumes a second-half margin rate in the -- let's call it, 14% range, consistent, actually a little bit better than what our guidance initially was for all of the year for ES.

So, we have brought it up a little bit.

But again, the performance adjustments, as I said, in many cases tend to be towards the end of the contract life, reflecting the resolution of contractual issues, or other kind of testing or acceptance types of issues.

And if they occur towards the end of a contract life, they do not have much of an impact on a go-forward basis.

So, the implication is that you think you've kind of reached the end with the first half --?

The implication is I think 14% margins for the second half of the year is great.

Okay.

Thanks, guys.

Myles Walton, Deutsche Bank.

Good afternoon.

I was hoping to focus on a separate segment, Aerospace, for a minute.

The segment's had great bookings over the last several quarters, really the last four or five.

Maybe it even gets a boost on bookings from the space area in the near term.

So, I'm just trying to understand, it sounds like a lot of the 2012 issues were anniversarying some things, whether that was ICBM or the change in accounting for F35 deliveries or lower F-18s.

Are those, or other areas, kind of headwinds to '13, or have we anniversaried those and this kind of increase in backlog that we've seen is putting you in a pretty good posture for actual growth in a tough environment in '13 in that unit?

Yes, Myles, for example, on F-35, we're kind of in the sine wave where we essentially had no sales or very little sales on the current production contract.

But we will have sales and margins as we go forward into the second half in '13, as deliveries on that contract occur.

Now, as I look at that business, I think that business is reflective of the long-term margin objectives that we've seen, or that I've talked about for Aerospace.

Clearly they've had some benefits on their existing backlog of contracts from the actions that they have taken to streamline the organization at AS.

That's had a benefit on this year's margins to the extent that the aerospace segment has longer-cycle contracts than probably most of the other business segments.

So, we're going to see some of that benefit continue as that existing backlog of contracts is worked off.

So, again, I feel good about where the Aerospace sector is, in terms of their margin objectives.

Yes, I guess, maybe I'm misusing words.

I was actually looking at the backlog and the bookings from a standpoint of actual orders.

The backlog's risen 23% in the last six months, and 35% in the last 12 months, and a lot of those -- and just focusing on top line, the sales headwinds you face this year, you have illustrated pretty well.

So, I'm just curious, I mean, '13, if I'm just looking at those two metrics, would seem to be pretty well positioned for top-line growth.

And just wondering -- is there any push-back outside of the obvious sequestration?

Besides that, I would say no.

Okay.

I'd say there's a good balance perspective here.

Clearly unmanned continues to be a very, very important part of the portfolio.

The manned parts of it, as Jim indicated on F-35, we have to kind of see what the program outlook appears to be.

We're going to have to watch how, even if we're not in sequestration, how some of the other budget decisions continue to get made as they affect other programs, for example in the space side.

So, we're delighted with the robust growth in the backlog.

I think that positions us very, very well for the future here.

I just would not want to get ahead of potential budget decisions that may ripple through the process here.

Okay, makes sense.

Thanks.

Okay.

Thanks, Myles.

Robert Stallard, Royal Bank of Canada.

Good afternoon.

Guys, I have a broader question for you.

As highlighted on this call, your margins are actually very strong.

You've also brought down your headcount in recent years, and now the customers are paying your higher CAS rates for you.

Do you think that there's the potential for political pushback as you and your peers try to avert the sequester as politicians point out that the defense industry is actually doing quite well at the moment?

There's always a potential for people to misuse facts, I would say.

If you look at our defense industry, we only do well when we're performing well.

And our customers have been very clear, and I think we've all seen that in our contract negotiations over the last several years, that we only have the contractual opportunity to do well when we perform well.

A lot of that is baked into the FAR.

So, when we think about our industry relative to other industries, we're not talking about extraordinary margin rates in the defense industry.

We're talking about margin rates that -- well, you can see what they are when you look across our industry and compare them to others.

So, I think if there are those who forget that connection between performance on programs and profitability, then you could say -- well, perhaps they're making too much somehow.

But the facts are, as I said, we only show good numbers when we actually perform well.

And as Jim has been indicating in much of his discussion around our margin rates, a lot of this comes down to our ability to not only execute, but to look at things in advance and take the actions we need to be taking to manage risks on behalf of our customers.

So, I'm not overly concerned about that.

In interacting with the seniors and the Department of Defense, they are very clear across the breadth of seniors on the acquisition side, and I would say on the policy side, that if we're performing, we ought to be able to make money.

Clearly if we're not performing, we ought to be penalized.

And that's kind of where I see that discussion sitting today.

Now, clearly, when we get down to the contract terms and conditions, there's a lot of pushing back and forth on the specific terms around profitability and cash flow and many of the other terms.

But all of that being said, from a -- kind of the 50,000-foot view and the policy view, I think we're in a very reasonable place here, where that connection between contract performance and financial performance is a pretty straight connection.

Jim, any other perspective?

I just want to clarify Rob's CAS comment, essentially because of the transition rules, higher CAS costs begin in 2014.

Right.

Not before.

Right.

Okay.

Thanks so much.

Robert Spingarn, Credit Suisse.

Good morning.

I guess it is afternoon.

Couple of questions there.

Wes, you've had some of the best bookings so far this year, and you talked earlier about embedding CR into your guidance, but because of that and the difference in your service business, which you highlighted earlier, are you less exposed to this CR than some of your peers?

Well, we have difficulty telling what the degree of exposure of all of our peers is, so I'd be reluctant to make a comparative comment in that regard.

Clearly our Information Systems business, and to some extent our Technical Services business, is a higher turnover business in terms of the rate at which contracts come on board and get executed and closed out.

And so, that higher rate, on a relative basis between those businesses and our AS and ES businesses, causes a little bit of more concern as we look at a CR environment.

But we've actually gotten pretty good at navigating the CR environments, and I'd say most of us around our industry have been dealing with this now for a while.

And our ability to plan and forecast the CR aspects of the environment, I think, is pretty good.

So, I'm having difficulty answering your question with regard to others in our industry, but I feel pretty good about our own outlook and forecast in that regard.

The challenge, I think, here isn't so much around the management of a short-term CR.

I think the challenge is -- how does the framework of a CR play into the concerns around sequestration, particularly as we get into the fourth quarter.

And part of the struggle that we're seeing in our customer community is that the political system, as I indicated earlier, is very focused around -- is there an approach that avoids sequestration?

Is there a broader perspective that can be taken?

Looking together at the tax law changes that -- or the current law coming into effect at the end of the year, the issues around the debt ceiling and everything the country went through last year and struggling to deal with the debt ceiling.

Is there a mechanism where all this can be brought together or not before the end of the year?

And the customer community is trying to figure out how they do the right thing to navigate through all of this.

So, I'm not as focused on the CR in terms of it's a variability, as I am on the potential variability of customer actions in anticipation of a potential sequestration.

So, at the very least, I think one of the things you're perhaps suggesting is we may see Q4 looking a lot different than Q3?

It's hard to tell.

I wouldn't want to speculate on that.

I would simply observe that there are environmental conditions that could potentially cause that to happen.

And then, just a final question on this for both of you.

For Wes, are you seeing any difference in the way the services are obligating funds these days?

And then, Jim, do you think that cash collections can become a problem as we get to the end of the year?

Let me just say on the obligations part of it, our understanding is that the guidance to contracting officers is for them to continue forward now, and we see them working hard to get things under contract.

Clearly, there are some areas are under more pressure than others, from a total budget perspective, and so they're struggling with this a little bit more than others.

And so, I'd say it varies a little bit across the portfolio, but in general, we see our customers working hard to hold everything together here.

On the cash collection question, I think probably the best way to put it, whether it's debt ceiling, all these different things that we potentially could be dealing with in the fourth quarter, we have really emphasized, as I said in my comments to our team, the importance of aggressively working our cash collections - doing billing and cash collections on a timely basis.

So that we can accelerate as much as cash is possible into the earlier parts of the year, than when it traditionally has occurred.

Again, since there's a lot of uncertainty around exactly what's going to happen and how it's going to happen, it's hard to tell whether or not cash collections are going to be affected in the fourth quarter.

But the best medicine is essentially -- move everything up, if you can.

So, it doesn't really impact your buyback plans?

I wouldn't think so.

Okay.

Thank you both.

George Shapiro, Shapiro Research.

Hello, good afternoon.

I wanted to try and get at this margin question maybe a little bit differently.

You had in the release that you got a lower margin on the F-18 multi-year as a transition.

Now, I'm assuming -- it could just be for the transition, but I'm assuming also that the overall realizable margin is probably less on the multi-year three than it was on multi-year two.

If you could go through -- is there a number that you could provide in terms of how much lower the margin potential might be on some of the new contracts that you're winning versus the current ones that you have in backlog?

Yes, George, you're looking at a situation where multi-year two at completion, you obviously know what you ended up doing.

You had a multi-year contract.

You've had the benefit of the multi-year, and taking cost reduction actions and affordability initiatives to improve the overall performance.

Multi-year three, we're at the very front end.

And so, it's not unusual to have a much lower earnings rate on the very front end of a contract, particularly multi-year contract, before you've had the opportunity to implement a number of the performance improvements and affordability initiatives.

So, I think we're at a point in time where we're comparing something that is known to something that has been negotiated that is a good contract, but we have in front of us all those other opportunities that we can take to improve the profitability, and it's too early to call whether all of them are going to be successful.

I recognize all that.

My question really was -- you've seen what you did for multi-year one to multi-year two.

My question really is -- is the potential on multi-year three in that regard, less?

And also if I could generalize to all of your other new contracts, whether the potential is less in terms of margin than what you've made or can make on the existing backlog, just to get a sense at the pressures your feeling from, if any, from the contracting people?

Clearly the environment is a little bit more difficult today than it was a couple years ago, and we're responding in terms of our cost affordability initiatives, and so, it's hard to say whether each of those are going to balance each other out over the longer term.

But it really comes down to us to continue to execute on our contracts to drive affordability, just as we've been doing over the years.

Each time we take on a contract, it's, as Jim indicated, there's uncertainty as to how far we'll be able to go in performance improvement and affordability improvement over time.

And what we're seeing is our team across the Company working really hard on this, and it shows in our results.

And we're really proud of that.

Exactly.

No, you've done a great job.

I'm just trying to get at how much steeper the hill may be going forward here.

It always looks steep when you stand at the bottom.

(laughter)

Thank you, George.

Thanks so much.

So, now, we have time for one more question.

David Strauss, UBS.

Hello.

Back to margins, I don't think you've addressed this.

You've gotten about 30% to 35% of your segment profit from cum adjustments in the first half.

What does the guidance assume specifically by the way, in terms of cum adjustments in the second half of the year?

A more normal level, if you want to call it that.

Actually, if you look at the quarter, the second quarter, and you compare the cum adjustments to the segment operating margin rate, it's 28% this year, 26% last year.

So, there really isn't that big a change in terms of the cum catch-up adjustments as a percent of the overall segment margin rate.

So, overall, margins in the second half, in terms of my guidance, is a little more, that's true.

That essentially implies a little less of those potential favorable adjustments.

But we'll go through a process every quarter of looking at our estimates at completion, and making the adjustments if necessary, up or down to reflect what we see as actual performance and resolution of any risk and opportunities at that point in time.

And then one on the revenue side.

I think when you started the year, you talked about having about $700 million in contingency or cushion in your revenue guidance.

Does that still exist, or have you eaten in to that?

And does that specifically relate to assuming that continuing resolution in the fourth quarter?

I don't recall any conversation around $700 million of contingency.

There is $700 million of variance in the range, if you will, 24.7 billion to 25.4 billion, but essentially that range reflects the possibilities for each of the four sectors, and where we think they may end the year.

Okay.

Thanks.

This concludes our Q&A session, and I'd like to turn the call over to Wes for closing comments.

Okay, thanks, Steve.

Let me just summarize by saying we had an outstanding quarter, reflecting our continued focus on performance.

We face a challenging environment, and we're certainly concerned about sequestration and the broader budget environment.

That said, we have a team that is focused on creating value for our shareholders, our customers, and all of our stakeholders, and we are prepared to deal with this environment.

Thanks for your continuing interest in our Company.

Ladies and gentlemen, that concludes the presentation.

Thank you for your participation.

You may now disconnect.

Have a great day.