諾斯洛普·格拉曼 (NOC) 2012 Q3 法說會逐字稿

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

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

(Operator Instructions).

This conference is being recorded for replay purposes.

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

You may proceed.

Thanks, Frances, and welcome to Northrop Grumman's third-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 Law.

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, CEO and President Wes Bush and our CFO Jim Palmer.

At this time I would like to turn the call over to Wes.

Thanks, Steve.

Good morning, everyone.

Thanks for joining us on our third quarter conference call.

We are very pleased with this quarter's results and the performance of our businesses year-to-date.

We continue to drive program performance, aggressively pursue high-quality new business with innovative, affordable solutions, reduce our cost structure and align our portfolio with our customer spending priorities in a dynamic environment.

Our intense focus on these actions, combined with effective cash deployment, continues to create value for our shareholders, customers and our employees.

These are not new initiatives for us.

These are the ongoing efforts and actions that have generated substantial performance improvement over the last few years and that will be increasingly important in today's challenging environment.

Third quarter EPS are comparable to last year despite continued top line pressure.

On a pension adjusted basis, our third quarter earnings per share increased 6%.

We achieved this improvement through a combination of operational performance and share repurchases.

All four of our businesses performed well in the quarter.

Our businesses continue to generate strong operating income, margin rates, and cash flow.

Year-to-date, we've captured more than $20 billion in new business awards for a book-to-bill ratio of more than 100%.

And cash generation has also been strong, even after our $300 million discretionary pension contribution, free cash flow totaled $748 million in the third quarter.

And year-to-date we generated free cash flow of $1.4 billion or nearly 100% of net income.

Our robust margin rates and cash conversion demonstrate the quality of our operational performance for the quarter and year-to-date.

We're very proud of our employees' outstanding efforts in generating these results.

Our strong cash generation continues to support share repurchases.

During the quarter we repurchased about 4.4 million shares of our stock for $290 million.

And year-to-date we've repurchased 13.6 million shares for approximately $850 million.

In the first nine months of the year, share repurchases and dividends have totaled more than $1.2 billion or nearly 90% of free cash flow.

We continually assess our share repurchase program to ensure that it's creating long-term shareholder value.

As you know, ours is a long cycle business and we take that perspective when considering the value of our enterprise.

We consider our long-term value relative to the market's current valuation of our cash flows and earnings.

Based on where we are in the cycle and the prices at which we are purchasing shares, we believe that share repurchases continue to contribute to long-term value creation.

The Board recently increased our remaining share repurchase authorization to $2 billion, which provides flexibility in a dynamic environment.

Turning to guidance, based on the strength of year-to-date results, we expect to end the year with sales of approximately $25 billion and we now expect 2012 earnings per share of $7.35 to $7.40.

On a pension-adjusted basis, this represents EPS growth of approximately 8% over last year.

We're also increasing our guidance for cash from operations and free cash flow.

Before discretionary pension contributions, we now expect operations to generate $2.5 billion to $2.8 billion with free cash flow of $2.1 billion to $2.4 billion.

Looking ahead to next year, there is substantial uncertainty regarding federal budgets, including whether sequestration will occur, and if so, how it would be implemented.

We believe that sequestration would not apply to obligated program funds that are currently in our funded backlog.

But there is little doubt that the long-term impact of sequestration would be highly detrimental to national security and our industrial base.

The short-term impacts, should sequestration take effect in January, are more difficult to assess given the lack of specific implementation detail.

As a result, we're preparing for a wide range of budget outcomes.

But under any scenario we expect that, as currently provided for under the Budget Control Act, sequestration would result in lower revenues, profits and cash flows for our Company and our industry over the long-term.

Now, in addition to sequestration and the potential impacts of the other fiscal cliff issues, we are now working under a six-month continuing resolution.

This CR is more challenging than previous years in that there appear to be virtually no exceptions for new program starts, which includes new tasks on IDIQ's and increases in production quantities.

There is also limited ability to effectively shift funding between programs as has been done in the past to mitigate execution issues.

There is no certainty when we will have a formal 2013 budget, and it is possible that the CR would need to be extended, which would be an additional source of uncertainty for us and our customer community.

So as we think about next year, our outlook is clouded by these challenges.

How all these issues are resolved will determine the degree to which our top line is impacted.

However, under any reasonable scenario we would expect lower 2013 sales as a result of the CR restriction on new starts, along with the other constraints our customer's facing.

We will be providing our detailed 2013 guidance when we announce our fourth quarter and year-end earnings.

In closing, it was a very good quarter and we expect a strong finish to the year.

Obviously, looking ahead to 2013 there is a high degree of uncertainty, as I said.

But we believe we are taking the right steps in the current environment by bringing innovative, affordable solutions to support our customers' needs.

And we believe we can continue to create value by remaining focused on our key priorities - performance, cash deployment, and portfolio.

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

Jim.

Thanks, Wes.

Good morning, ladies and gentlemen.

The highlights for the quarter were outstanding cash generation and strong, consistent segment operating margin rates.

This performance, combined with share repurchases, generated this quarter's 6% increase in pension adjusted earnings per share.

Now let's spend a few minutes looking at some of the details behind the results.

Those results reflect our continued focus on program execution and aggressive cost management and reduction activities.

Although operating income declined by the $66 million change in the net FAS/CAS pension adjustment, on a pension adjusted basis our operating margin rate expanded 20 basis points to 11.2%.

In addition to the pension impacts, operating income also reflects lower volume, which was partially offset by an improvement in corporate unallocated expenses.

EAC adjustments for the quarter were net positive $214 million versus $196 million in the prior-year third quarter.

The primary driver of the change was a $38 million reduction in unfavorable performance adjustments compared to last year's third quarter.

Based on our year-to-date performance, we now expect 2012 segment operating margin rate of approximately 12% with a total operating margin rate in the high 11% range.

As I mentioned, cash results for the quarter were simply outstanding.

During the quarter we did make a $300 million discretionary contribution to our pension plans, which, after tax considerations reduced third quarter cash from operations and free cash flow by $221 million.

Year-to-date, cash from operations is more than $500 million ahead of last year's pace and free cash flow is nearly $700 million higher.

Given that performance, we are raising our guidance for 2012 cash from operations and free cash flow.

But in doing so, I should caveat that by noting that our guidance does not contemplate any unusual year-end customer behavior due to pending issues such as the debt ceiling, the fiscal cliff, or potential sequestration.

Turning to the sectors, Aerospace third quarter sales increased $131 million, or 5%.

We continue to see growth in our unmanned systems portfolio, principally due to the ramp up on programs such as NATO AGS and Fire Scout.

Military aircraft sales also increased due to higher F-35 volume, which includes deliveries of the first units under the LRIP-5 program for F-35.

You will recall that we adopted the units of delivery revenue recognition for F-35 LRIP 5 and we are now recognizing LRIP 5 revenues with the commencements of the deliveries in this quarter.

Higher volume for unmanned and military aircraft was partially offset by lower sales for space system programs, including some restricted programs and the impact of the DWSS termination in the fourth quarter of last year.

Aerospace operating income declined by 2% and resulted in operating margin rate of 11.1% for the quarter compared to 12% for last year's quarter.

The major change in the margin rate is a transition to the lower margin multi-year three contract on the F-18.

For the year, we expect aerospace sales of about $9.9 billion with a margin rate in the mid to high 11% range.

Electronic Systems sales declined by $198 million, or 10%, due to lower revenue and postal automation, combat avionics, infrared countermeasures and laser systems.

Postal automation includes the de-emphasis of our domestic postal automation business, as well as a softening in international postal sales in Europe.

Combat avionics sales declined due to lower unit deliveries for several programs, including the F-22.

And infrared counter measures and laser system programs declined due to force reductions in overseas contingency operations.

These declines were partially offset by higher volume for some space systems programs.

ES operating income declined 5% and operating margin rate increased 90 basis points to 16.3%.

You may recall that last year's third quarter included a $25 million provision for the domestic postal automation program, and without that provision, last year's operating margin rate would be comparable to this year.

For the year, we expect ES revenues of approximately $7 billion with a margin rate of low to mid 16%, up from our prior guidance of low to mid 15%.

Information system sales declined $179 million, or approximately 9% for the quarter.

About $100 million of that is due to the wind down or completion of programs, including JTRS AMF, and several restricted programs.

Another $30 million is associated with in-theater force reductions, and finally the sale of Park Air Norway impacted third-quarter sales by $17 million.

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

Consistent with third quarter sales trends, IS operating margin declined 9% while operating margin rate was unchanged at 9.6%.

For the year, we now expect IS sales of approximately $7.3 billion and we continue to expect a 10% operating margin rate for IS for this year.

Turning to Technical Services, third quarter sales fell 6% largely due to lower volume for the KC10 program.

Our previously announced portfolio shaping actions in defense and government services also reduced third quarter sales.

On an absolute basis TS operating income was comparable to the prior year with operating margin rate expanding 40 basis points to 8.3% due to improved program performance.

For the year, we now expect TS sales of approximately $3 billion with margin rates in the high 8% range.

On a consolidated basis, we are looking for 2012 sales of approximately $25 billion and we're increasing our segment operating margin rate guidance to approximately 12% with total operating margin rate guidance to the high 11% range.

Now let's spend a few minutes talking about everybody's favorite subject, 2013 pension.

I should remind you that there are a number of assumptions that we determine at the end of the year that will principally affect FAS pension costs in 2013.

Two of those key assumptions that are critical are the actual return on investment assets in 2012 and then the discount rate used to discount pension liabilities at the end of the year.

Now, through September 30th our actual asset investment return is approximately 10% compared to an expected long-term rate of return of 8.25%.

And I think you'll recall that every 100 basis points above or below the expected rate of return affects 2013 FAS expense by $40 million.

And if we had to set the discount rate at September 30th, we would likely be looking at about 100 basis points lower than what we use to discount liabilities last year.

And again, just a reminder that I think you know, we are required to set all of these assumptions at the end of the year.

And so with a little over two months to go, we may continue to see volatility, particularly in interest rates, due to matters such as the pending fiscal cliff or global economic factors.

But again for modeling purposes, just a reminder, every 25 basis points change in the discount rate impacts 2013 FAS expense by about anywhere in the $75 million to $80 million range.

So at the start of the year, again a reminder, we had estimated our 2013 net FAS/CAS income to be about $250 million, and obviously that estimate had assumed no change in the discount rate or asset returns above or below the long-term rate of return assumption of 8.25%.

Our estimate for CAS for next year has not changed much, but obviously interest rates and planned asset returns, among other assumptions, will have a significant impact on 2013 FAS expense.

So, Steve, in closing, I would say the very strong operational performance that we've seen for the first two quarters continued into the third quarter.

We expect a strong finish to the year, as I said.

Strong cash flow.

So bearing any unusual customer behaviors resulting from the uncertainty in the budget environment, I think we are going to have a strong finish to the year.

With that, I think we are ready for Q&A.

Thanks, Jim.

As a reminder each participant should limit themselves to a single question.

If you care to get in the queue, after your first question again, you are welcome to do that.

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

Thank you.

(Operator Instructions) Our first question is from the line of Myles Walton from Deutsche Bank.

You may proceed.

Good morning, Myles.

Good morning.

Wes, you alluded to 2013.

You'd have some top line pressure regardless of the sequestration situation that evolves.

Curious.

Could you comment on the margin side, Jim or Wes, regardless of -- or let's assume no sequestration?

What kind, if any, headwind on the margin side we should anticipate?

Obviously, you had a strong performance on EACs and the negative EACs continue to come down.

I just don't know how much more opportunity there is for the unfavorables to come down.

If you could kind of elaborate maybe just at the high level.

Myles, let me give you a range of thoughts here.

Clearly, 2012 we've had a benefit from the cost reduction activities we have undertaken over the last year and a half in terms of our existing backlog.

Some of that backlog continues to have those benefits on a go-forward basis.

Secondly, I would observe that the contracting environment is a little bit more difficult than it has been in the past.

It means that we've got to be diligent about terms and conditions in contract structure.

And most importantly, it means that we have to do what we are charged to do.

Manage our programs.

Thirdly, we do take a look every year at long-term rate of return assumptions for our four business areas.

I'm very comfortable with where we are, but we'll take another look at that based on what we see as performance in the industry.

And we may revise those or we may continue to hold them, the long-term rate of return assumptions that we have today.

But again I feel very good about where we are in terms of the businesses.

Clearly, our job is to do better than those long-term rate of return assumptions and we have been able to do that over the last couple of years basically through the combination of affordability initiatives and then managing the programs.

And then finally, we are not standing still.

We continue to take actions to improve affordability within the Company, which again it will get us an advantage on the existing backlog even for new contracts that we negotiate today.

So, in summary, I would say just outstanding performance from the team for this year and I feel good about the long-term view of the businesses and what the margins ought to be able to generate and it's up to us to manage our programs.

The line of Doug Harned from Sanford Bernstein.

Good morning.

I am interested thinking about the top-line outlook because if you look at what you have done over the last few years in terms of reshaping the portfolio, exiting some businesses, ramping down some things like activities in the postal automation area.

And then, you know, OCO funding coming down.

So you've had some things that have taken the top line down.

A few contract cancellations.

So are we at a point where you can sort of reset the business?

And if we set sequestration aside, are we at a point where as you look forward are we looking at something that's stable, declining, or even maybe, you know, some modest growth out over the next few years?

Doug, let me frame it this way.

If we look at 2013 in particular, you know, clearly sequestration is a big, big variable in all of this.

But to the point of your question, if we set it aside, the other reality that we are dealing with now is this continuing resolution six months CR.

And it's a pretty tight CR in terms of the way that it's crafted.

It puts an enormous number of constraints on our customer community with respect to what they can do on new starts, or transitions into production, or even under IDIQs.

Given that appears to be at least a six-month concern, that will put negative pressure on the top line.

Sort of across the board, that's going to be a fact of life that we're dealing with.

So ultimately stability in our top line will go hand in hand with greater stability in how the government is appropriating and executing the budgets that are allocated for defense.

And the other agencies that we serve.

The other factor, though, that I would say needs to be considered even if you set aside sequestration is just how much money is going to be allocated for defense ultimately in the budget environment.

We all know that there is a substantial deficit situation and that there are some tough decisions that lie ahead to be made regarding the outcomes for each component of that budget.

So it's a little unclear today from where we are, you know, how to predict how that will go.

But to the point that you made, we feel good about how our portfolio is positioned in that regard.

We feel that we've got -- done a good job of getting aligned on priorities.

So when those budgets get set, it's our expectation that our portfolio will do well in a relative sense against those priorities.

The other longer-term opportunity for the Company continues to be on the international side.

As you know, our international sales historically have been largely confined to our electronics business.

And while we have been very pleased with those sales and the team at electronics has done a great job of making those sales very effective for us, we see additional opportunities emerging.

Particularly in our Aerospace Systems business, but also in IS and TS as we take a broader look and engage with our DoD customers in terms of their strategy on what they would like to see our partners around the globe be able to do.

We see a growing push to take some of the capabilities that historically we have had some challenges exporting.

We see a growing push to make those more available to our partners.

So that's not a near-term thing.

It takes work to get those through the policy arena and then actually executed in terms of specific programmatic decisions.

But we also see our portfolio as being well aligned for some of the important thrusts that we see from an emerging policy perspective in supporting our allies around the globe.

Your next question is from the line of Sam Pearlstein from Wells Fargo.

You may proceed.

Good morning.

Hi, Sam.

I'm sorry to kind of try and do two parts here, but Wes, just to continue on the Continuing Resolution question, isn't the absolute level of the CR higher than what the original request is?

And so wouldn't that actually, in some ways, be beneficial?

And maybe you can talk about some of the new starts that you have expected this year that get pushed out.

Well, it is just very slightly higher in a total magnitude sense.

But what ultimately counts is what the constraints are that get implemented program by program.

So you have to sort of peel that apart.

And, you know, we're all glad that the total number for the CR was a good number relative to the President's budget.

But when it comes to executing programs, particularly programs that are in any form of transition, if it's a transition from development to production, if it's an IDIQ contract where you're finishing off a task order on an IDIQ contract and they want to issue a new task and, you know, if you're just looking at the broader set of constraints that went with them.

This was a very tightly prescribed CR.

More tightly than we have seen in the past.

So that was really the comment that I had on why that is an issue relative to how the top line will work.

Just about every program in our community has a fair amount of variability around where the funding is coming from.

What the line items are.

And when you start putting those types of constraints on it, it does have implications in what our customers can do.

So it's all of our hope that we move through this CR as expeditiously as we can and get a real piece of legislation that really does the appropriations the way they need to be done so that our customer community can go execute on their mission.

That's at a top level our primary concern.

I think it tends to impact our shorter cycle businesses more dramatically.

But even some of our more substantial programs that are making that transition from design into production could be impacted by those constraints depending on the timing of the actual appropriations language and how long we actually live under the CR environment.

Your next question is from the line of Noah Poponak from Goldman Sachs.

You may proceed.

Hi.

Good morning, everybody.

Good morning.

One minute to the afternoon.

Hi.

I just wanted to ask, when I'm looking at the balance sheet it looks like you'll end the year close to or in a small net cash position.

You know, rates are particularly low out there right now.

I wonder how you just think about, you know, the right level of balance sheet utilization.

And, you know, there is obviously plenty of uncertainty ahead, particularly in the near term.

But you could add, you know, a significant amount to the balance sheet and still keep your leverage metrics fairly low.

Or perhaps you just want to wait until the sequestration outcome is resolved.

But if you could just speak to, you know, how you're thinking about that broadly, that would be very helpful.

Thank you.

You're correct, Noah.

Your observation -- we have a very conservative balance sheet at this point in time.

We view flexibility as very important.

The cash balances provide us that flexibility in this uncertain environment.

Having some certainty around future budget outlooks would be really important.

We're mindful of where interest rates are.

We've watched them very carefully.

I don't know that we're going to see a significant change in interest rates in the near term.

I would like to believe that we are, but I doubt that we are.

So I think that the market flexibility will likely remain for a reasonable period of time that we wanted to take advantage of that, we would have the opportunity.

But in today's environment having the flexibility that our capital structure reflects today is really important.

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

You may proceed.

Thanks.

Good afternoon now, everyone.

Hi, Joe.

I would like to get back to a strategic question that, if not new, but just to get your latest thinking on it for either or both of you.

It has to do with share repurchase.

You guys are continuing to -- it's your primary use of free cash flow.

It's about half of what you're looking for in terms of cash flow before pension contributions this year, is what you are on track to do.

And you know you are indicating that sales are going to face pressure next year.

You're indicating that margins are still above their long-term rate.

And so when you evaluate the value in your stock to repurchase it, and I would like to get an update on how you think about doing that and you how you plan to modulate your repurchase activity based on where your stock is.

Joe, it's Wes.

You know, I touched on this a little bit in my remarks and I think it's important to be, you know, clear will how we think about this.

As I said in my remarks, we are a long cycle business.

And when we think about this, we are looking at longer term value.

We are a business that generates good cash flows.

As we assess how that's going in terms of how the market is valuing our shares, we play that directly into our own model of long-term value creation and our assessment is that share repurchases have continued to be a very, very good use of our cash.

In fact, as I pointed out in my remarks and as we announced a few weeks ago, the board increased our remaining share repurchase authorization to $2 billion to make sure we've got appropriate flexibility as we go forward.

So we continue to look at share repurchase as a very good use of our cash.

We clearly compare that to all of the other alternative uses.

You know, first and foremost, we always make sure that we are investing appropriately in our business to make sure that we are realizing that the opportunities that are represented by the strength of our portfolio.

So that is always our primary thinking.

We pay a lot of attention to our pension plan to make sure that it is in good funding condition and we continue to do that.

You saw that just here in the quarter we made an additional investment in our pension plan.

And I think we've been in a good place on our dividend.

We raised our dividend 10% this year.

But when we mix all of those things together, we like what we have been doing on share repurchase.

We do think it is a very good use of the cash flows that we are generating.

And like the opportunity that it presents for value creation in our Company.

Jim, was there any perspective you would like to add to that?

I would just reiterate your comments.

We continue to have a balanced cash deployment strategy of investing in the business, managing our balance sheet, and returning any excess cash to our shareholders.

Traditionally, our dividend and share repurchases have kind of been in a 40% ratio for dividends.

The balance in share repurchases.

If you look back over quite a bit, a long period of time, absent last year's large share repurchases after the spinoff of shipbuilding.

So I'm -- you and I are in the same place.

Good.

Your next question comes from the line of Robert Stallard from RBC Bank.

You may proceed.

Good afternoon.

Hi, Robert.

I am not sure if it was Jim or Wes.

One of you mentioned about the shorter cycle areas of your business being a bit weaker in the quarter.

Can you quantify how much this might be down and if you expect this perhaps to catch up at some point in the future.

And also if you are seeing increased competition in some of these short cycle areas.

Thank you.

Actually, book to bill ratios in the -- both on a quarter and year-to-date basis are essentially around one or above one.

And I think in all of our businesses except TS we're at 0.97 on a year-to-date basis.

Frankly, compared to last year at this point in time our book to bill is ahead of where we were.

Yes.

I think one of the comments we made earlier was, as we look ahead into the CR environment, we do have a little bit more concern about some of the shorter cycle businesses giving the constraints on new starts, if you will, in the way the CR has been implemented.

So that's sort of a programmatic funding issue that we would have that I think would manifest in the shorter cycle businesses.

But as I pointed out, it can even impact our longer cycle businesses at the point that programs are transitioning in some way that would be impacted by the constraints of the Continuing Resolution.

And your next question is from the line of Howard Rubel from Jefferies.

You may proceed.

Thank you.

Excuse me.

Thank you.

Hey, Howard.

Thank you, Wes, and Jim.

Good afternoon.

You have changed your focus on bidding it seems, Wes.

And maybe for a moment you might want to talk about that.

And it looks like it's impacting maybe your capital spending as well.

In a sense, it's much more information technology and maybe less capital intensive and more intellectual intensive?

Yes.

Our focus in our bidding has really been to make sure that we are pursuing the business base that will be high-quality business for the longer term for the Company.

And your point within our information systems business is right on.

You know, we have over time transitioned that business from a business that had a much greater fraction of sort of lower commodity businesses to a much higher end, more intellectual capital, much more engineering content business.

That's the transition that has been underway these last few years, and I think that's serving us well.

It allows us to be very thoughtful about where we are applying our resources, both our capital as well as our internal R&D and then proposal investments.

And it's allowed us to make sure that the businesses that we pursue there really have some form of competitive -- sustainable, competitive differentiation that generates value so that we are not just turning them over in a very quick mode as we would often see in the lower commodity businesses.

We have been making that transition in Technical Services as well.

And over the last couple of years have really fundamentally transformed the portfolio in businesses within TS to go after the areas that require more intellectual capital, if you will, around modernization or some of the training solutions or even in the services side of that, the areas that require the broader applications of the capabilities that we bring forward as a company.

So that transition has been underway.

It continues still a little bit, but I think we've come much of the distance we needed to go to make that transformation.

I like where it positions us in the marketplace when it comes to the areas of highest priority for us to pursue.

The things that we have talked about extensively.

Cyber security is a good example of that.

The modernization work we are doing in Technical Services is another good example of that.

So it's been an important shift for us.

Jim, anything you would like to add?

I would just observe, Howard, that the decline in CapEx that you are seeing, you might remember that we moved from California a year ago.

Bought a building.

That's probably the biggest driver in the decline --

year-over-year.

Year to year.

Yes.

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

You may proceed.

Yes.

Thank you.

First question on pension.

You know, it looks like, you know, with your good return, you know, your under funding will be down this year and so that -- I mean, by my numbers if the discount rate went up by something like 50 to 75 bps, you might actually be fully -- very fully funded.

And so, you know, taking that into account, I mean, do you think it's a good -- do you plan on making more pension contributions next year if we kind of close where we are today?

And if so, you know, how do you view the attractiveness or lack thereof of being, you know, more than fully funded?

I think, Cai, I think there is an advantage to have a very well funded plan.

There are some practical limits to that as well.

If and when we see a move up in interest rates that reduces the liabilities back to, frankly, a move back to more historical levels, you're right.

That will significantly improve the otherwise under funded situation that we see today.

Given where interest rates are, you know, not only is a 25 basis point move in discount rate, which we talked about being potentially 100 basis points lower, and contributing to pension expense of $75 million to $80 million, a 25 basis points move is $750 million of liability -- change in liability.

So you're right in observing that a move up, if and when we get that in terms of interest rates, will have a significant impact on the funded situation of the plans.

Just like our view of the Company, this is a long-term decision that we made for providing employee benefits for our employees.

We need to think about it in that way.

I don't have significant cash contributions.

I don't have any -- my required contributions next year at this point look to be in the range of, let's call it $75 million.

So not a significant use of cash.

But as we mentioned before, we think about our cash deployment across the total opportunity set that we see.

We clearly want to invest in the business and continue our, I think, leading portfolio.

We want to manage the liability side of our balance sheet by both investing in the pension plans when it makes sense.

We have debt that matures in the next couple years.

So we need to be thinking about what we want do there, whether we replace it or pay it off when it matures.

And then ultimately we'll return excess cash to shareholders.

So our view really hasn't changed and we need to think about the pension plan on a long-term basis.

But if and when we do see changes in interest rates moving up, it will improve the funded situation of the plans and likely will have a similar impact on our required funding.

Your next question comes from the line of Jason Gursky from Citi.

You may proceed.

Good afternoon, everyone.

Hi, Jason.

Thanks for taking the question here.

I just wanted to drive down a little bit to get a sense from you on sequester and the potential sensitivities around that.

It would seem that shorter-cycle businesses would be the ones that would get hurt the most.

The quickest given the fact that you have annual renewals on a lot of contracts.

I was wondering if you could just talk a little bit about whether you have visibility on what percent of your firm's overall business you would characterize as short cycle at this point and would be subject to kind of the whims of sequester and the short-cycle nature of the pressure that we might see.

So, Jason, let me -- and I appreciate the question because, you know, this is an area where, as I mentioned in my remarks, there's a lot of uncertainty first and foremost about whether sequester would happen.

But then should it happen, how that would all roll out.

As I think I mentioned in my opening remarks, we would not expect to see obligated funding hit in sequester.

It is, I think, the case that it would take a little bit of time for each of the departments and agencies to sort through what they would need to do contractually as a result of sequestration.

You know, just the pure mechanics of that process would be daunting.

If I were putting myself in the shoes of our customer community to really deal with such a thing.

So it's hard to predict.

And so I wouldn't want to get too far ahead of trying to predict how that would actually work out.

But I do think that the principle that you indicated is probably correct that the services businesses would -- if a sequester were to occur and persist for some period of time, would probably be impacted sooner in that they have the higher turn rate of their contracting base.

And consequently, they burn through the obligated amounts and encounter a new contract decision more quickly.

And also the customer more likely would be in a position where we would be having to deal with those types of contracts sooner than the longer cycle development and production contracts, although ultimately if that sequester persisted all of those things could be under a lot of pressure.

So it's a little bit hard for us to come up with some percentages on that.

You know, we have done a lot of modeling for different scenarios.

I wouldn't want to go on record pinpointing a particular scenario that I thought was most likely because, as I said, this is going to be a very, very dynamic environment.

Should we find ourselves in that position of a sequestration actually getting implemented.

It would be very, very tough on our industry.

But I would also say it will be very, very tough on our customer community and the challenges they would face and the decisions they would have to take.

None of us envy anybody being in that kind of a position.

Your next question comes from the line of Carter Copeland from Barclays.

You may proceed.

Good afternoon, guys.

Hi, Carter.

To expand on that a bit, Wes, you say you've evaluated a number of scenarios.

I wonder just to kind of be specific about something that's hard to be specific about, is there a scenario where the impact to revenues, earnings, and cash in 2013 is greater than a cut we'd expect to see to DoD outlays in the event of sequestration if, as you stated previously, obligated funds on contract are unaffected.

I think if would be difficult to see an impact of that sort of magnitude.

But I wanted to see if you would agree with that based on what your evaluation of the scenarios showed today.

Yes.

You know, I think ultimately, just if you think about the mechanics, there is the factor around the obligated funding that we mentioned.

Yes, that's sort of a consistent way of thinking about it.

But there is also the factor, the real factor of just the time it would take for a turn on contracts and the rest of it.

So, you know, it probably would not be an overnight thing.

It would take a little bit of time to manifest.

But the real problem, I would say, is not just an end-year issue.

It's the long-term impact that would result from the set of actions that would be taken, that would fundamentally disrupt programs and the industrial base in a profound way.

And that's why, you know, from our perspective, we have said it a number of times, this would, you know, certainly impact sales and profits and cash flows.

But we are all as concerned about what it would mean to the stability of the programs, the stability of the industrial base, the people in the industrial base.

All of the other aspects that would ultimately translate into the ability to deliver the national security solutions.

So just, you know, just working the mechanics of it, there is a lot of speculation about how mechanics would work.

Long term, I don't think I have to speculate when saying that the impacts would be profound and very, very negative and it would take us all a long time to turn back the cycle in that.

Jim, I don't know if you want to add anything from the financial aspects of your thinking on it?

All of which again I would agree with.

And Carter, if you think about the nature of the accounting method, percentage of completion that we in the industry use, essentially significant changes in your cost structure have a cumulative catch-up impact.

So, yes, I could imagine a situation where a change in cost structure or revenues by X amount result in a different percentage change in margins for the Company or the industry.

Yes, with the cumulative catch up.

Yes.

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

You may proceed.

Hi, guys.

Apologies for this but I want to continue in this direction.

Mainly because the irony is that while I think most of us think there might be a negotiated settlement here at some point, what's on record is the most onerous outcome.

Maybe another way of approaching this, Wes, is how do we think about the dispersion in outlay form.

The FY'13 funds to Northrop via the request over a chronological time period?

So those funds that Northrop would receive through the President's '13 request, if it were to go through, when do those outlays -- in which fiscal years for Northrop?

Is it 25% in '14?

Some number is '15 and '16?

How do we think about that?

I won't go through the details of that.

Obviously, it's been a part of our modeling.

It varies, as you might imagine, by the different components of our businesses.

Some of the monies that get appropriated, the actual outlays occur over several years.

Sometimes two.

Sometimes three.

And some of the appropriated monies get burned up in the cycle.

And you can imagine which of the businesses go with which.

So there is a burn-through of all of that.

I think perhaps though a bigger question is should our customer community find themselves in a situation where there has been, either by overt decision or by failure of the Congress to actually change direction, basically a national conclusion that we are going to do something as draconian as implement a sequester.

What actions will our customers have to stand back and do -- take from a broader strategic perspective?

So, you know, there is kind of that mechanical part of outlays and obligations and all of that.

But the real question at that point in time would be strategic and what the longer term implications would be of having to rethink a fundamentally much smaller budget within which to execute the national security mission while the threats around the globe and the issues that our service men and women are called upon to execute continues to grow.

To me that's actually the bigger question here.

It's not so much the end-year outlays and the implications of the mechanics in 2013, it is where would that take us?

And that's what I think we need to be mindful of.

(Operator Instructions) Our next question comes from the line of George Shapiro from Shapiro Research.

You may proceed.

Good morning.

Hey, George.

Hey, George.

I just wanted to get an update.

I don't think you've signed an LRIP 4 contract.

You haven't signed LRIP 5, because Lockheed hasn't either.

So how do you decide what to book for profit when you're making these deliveries under those contracts?

And then just one other one I'd throw in.

Where do you stand with Block 30?

It doesn't look like anything's happening in terms of canceling that either.

Actually, George, we are negotiated on LRIP 4 and LRIP 5.

All right.

So you -- when did you wind up -- ?

We are negotiated so we have a good basis for thinking about margin rates on the contracts.

George, let me take on the question around Block 30.

We've -- we continue to work closely with the Air Force on all the blocks of Global Hawk.

The Air Force has continued to fly the Block 30s and we continue to support that activity and we continue to work with them to make sure that all of the capabilities and operational activities that are needed to continue to make that asset valuable to the Air Force and more broadly valuable to the COCOMs are being implemented.

So it's a category that we continue to work very closely with the Air Force and the combatant commanders continue to ask for the asset to be utilized.

And your next question as a follow-up from the line of Howard Rubel from Jefferies.

You may proceed.

Thank you, very much.

Jim or Wes, one of the other issues that is going to happen with the sequester is the civilian work force also would be cut very sharply.

That probably has as much of an impact on what would happen as anything else.

Is that a fair way to think about it?

It's a very fair way and it's one of our very big concerns.

You know, clearly, the civilian work force in the DoD and the intelligence community represent an enormous foundation of knowledge and perspective in implementing the national security mission, which we're all focused on executing.

So the concept of a major reduction in that work force would have very, very long-term implications.

It's also a big concern beyond the DoD and something that I think is sometimes not illuminated adequately in this discussion around sequester.

Half of sequester goes to the DoD and sort of the national security side of the budget.

But the other half, fully the other half goes to the other federal agencies.

And so we're talking about impacting individuals who support air traffic control.

Individuals who support all of the federal enforcement agencies and law enforcement agencies across the board.

We're talking about potentially impacts to food safety, to the activities that are underway to ensure that, you know, that the nation is able to deal with diseases and epidemics.

All of those sorts of issues are on the table every bit as much.

And when you think about those other agencies, they don't have as large a procurement budget as does the national security side of the equation.

And since they don't have as large a procurement budget, when they go to take this full 50% of the hit, it will translate into even greater impacts on the civilian employees of those agencies.

So this is a broader set of national issues and national concerns than just the defense community.

And I think that deserves more illumination in the debate around the appropriateness of using this very blunt instrument of sequestration to address the fiscal challenges.

At this time, gentlemen, there are no other questions.

I'd now like to turn the call back over to Mr. Steve Movius for your closing remarks.

Thank you, Frances.

I think I will turn the call over to Wes for his close.

Thanks.

Let me summarize by saying quickly again we are very pleased with the performance of our businesses in the quarter and all the way through the year.

Clearly, this continuing focus on performance, on cash deployment and on our portfolio is making an impact.

It's making a difference and we're pleased with the outcomes that we're seeing this year.

We certainly appreciate all of your interest in our Company and thank you again for joining us on our third quarter call.

Thanks, everyone.

And, ladies and gentlemen, this concludes your presentation.

You may now disconnect, and have a good day.