諾斯洛普·格拉曼 (NOC) 2012 Q4 法說會逐字稿

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

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

Later, we will facilitate 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 call over to Steve Movius, Vice President of Investor Relations.

You may proceed.

Thanks, Frances, and welcome to Northrop Grumman's fourth-quarter and year-end 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 calls 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, 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, and thanks for joining us.

We had a very strong finish to the year, with outstanding fourth-quarter and full-year results.

We met or exceeded guidance for every metric, and I want to congratulate our employees on a job well done.

Fourth-quarter earnings per share increased 2% to $2.14; and for the full year, earnings per share rose 5% to $7.81.

On a pension-adjusted basis, EPS increased 11% in the fourth quarter to $2.06, and 15% for the year to $7.47.

Our financial results demonstrate the positive impact of superior program performance, driven by cost reductions, affordability initiatives, innovation, and portfolio shaping across our four Businesses.

The strength of our sector's operating performance, coupled with continued share repurchases, more than offset lower sales, higher pension expense, and higher effective tax rates.

Cash generation was also strong.

For the year, before the impact of pension pre-funding, we generated cash from operations of $2.8 billion and free cash flow of $2.5 billion.

On our reported basis, free cash flow of $2.3 billion represents a free cash flow yield of 14.3% and net income conversion of 117%.

We deployed that cash by repurchasing 20.9 million shares of our common stock, for $1.3 billion, reducing weighted average shares outstanding by 10%.

We also paid dividends of $535 million and made a $300 million discretionary pension contribution.

Through share repurchases and dividends, we returned more than $1.8 billion in cash to our shareholders, or approximately 80% of 2012 reported free cash flow.

We captured new awards of $26.5 billion during the year, for a book-to-bill of 1.05.

Total backlog increased 3% to $40.8 billion, and funded backlog increased more than 10% to $25.7 billion.

I'm very proud of the performance improvement accomplished by our team.

Achieving these improvements has required tough but necessary actions.

To put our improvement into perspective, since the end of 2009, sales from our continuing operations have declined about 9%, due, in part, to portfolio shaping.

During that same period, our focus on performance has generated a 20% increase in absolute segment operating income, and a 300-basis points expansion in segment operating margin rate, or more than a 30% improvement.

As a result of this improvement, in combination with effective cash deployment, EPS from continuing operations have grown by a compound annual growth rate of 20%.

While superior program performance and portfolio shaping drove much of the improvement, we've also significantly reduced our cost structure.

Over the last four years, we have reduced our head count by approximately 17% and we have reduced our facilities footprint by approximately 12%.

As we improved operating income and margin rate, we maintained robust free cash flow and free cash flow conversion.

We also monetized assets to create value for shareholders.

Over just the past three years, we've generated free cash flow of $7 billion, including the $1.4 billion contribution from the HII Spin-off.

More than 90% of that cash has been distributed to our shareholders -- $4.8 billion to repurchase shares and another $1.6 billion for dividends.

In addition, we increased the dividend in each of these three years.

Looking ahead, I can't recall a time with greater uncertainty regarding customer funding levels or government fiscal policy.

We continue to operate under a six-month continuing resolution that expires on March 27, and there is the potential for sequestration on March 1. In addition, other issues, such as the debt ceiling, raise the possibility of a potential government shutdown.

Our nation needs a balanced, strategic approach to our fiscal challenges.

Blind, indiscriminate budget cutting is not the answer, but that is exactly what sequestration would entail.

We urge Congress to work to avoid the destructive economic impacts, particularly in terms of government and private employment, and the impacts to our national security that would result from a sequester, a prolonged, restricted continuing resolution, or a government shutdown.

Our 2013 financial guidance is based on the assumption that the current six-month continuing resolution will be immediately followed by appropriations, which, even if in the form of a full-year CR, will provide program spending levels that are consistent with those set forth in the President's fiscal year 2013 budget, and that support and fund the Company's programs.

Guidance for 2013 also assumes there is no disruption or shutdown of government operations resulting from a federal government debt ceiling breach or lack of immediate appropriations following the current CR, the sequestration is not triggered, and any budgetary approach agreed by Congress to address longer-term spending does not result in significant reductions to our customers' FY '13 budget levels.

While we don't have control over these issues and can't predict their ultimate resolution, I believe the work we've done over the last several years on performance, as well as our strong balance sheet, leaves us well prepared for a likely defense spending downturn.

For 2013, we expect sales of approximately $24 billion, earnings per share of $6.85 to $7.15, cash from operations of $2.1 billion to $2.4 billion and free cash flow of $1.7 billion to $2.0 billion.

Our top line guidance contemplates a $500 million impact for lower volume on space programs, Joint STARS, and FA-18; $300 million for the impact of troop drawdowns and overseas contingency operations; $200 million resulting from the current CR impacts; and approximately $100 million each for the ICBM program restructure and portfolio shaping, principally, the de-emphasis of base and range operations in our technical services business and the Park Air Norway divestiture in information systems.

Beyond that, we expect low single-digit growth for our core capabilities in cyber and unmanned systems.

We also expect higher international revenue.

In 2012, international revenue, both direct and FMS, totaled approximately 8%.

In 2013, with the ramp up of NATO AGS and other international bookings, we expect international sales to increase to more than 10% of our revenue, and we see continuing opportunities around the globe that our portfolio should allow us to address.

In conclusion, our 2012 results demonstrate strong performance in a challenging environment.

In order to continue creating shareholder value, we must remain absolutely focused on our key priorities -- driving performance, effectively deploying our cash, and optimizing our portfolio for the future.

Our record these past few years demonstrates we can do this successfully, and I'm delighted to be working with our Company's talented team to create long-term, sustained value.

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.

I also want to add my congratulations to our team on their outstanding work this year.

2012 results were simply excellent.

Our dedicated team again rose to the challenge and performed very well in a tough environment.

We continue to make the difficult decisions to reduce costs, improve affordability that are helpful in translating to our record results.

Let me give you a few numbers to put our performance into perspective.

Segment operating margin rate of 13.5% for the quarter, and a record 12.6% for the year.

Pension-adjusted operating margin rate of 11.9% for the year, also a record.

I'm particularly pleased by the cash our operations generated this year.

Wes noted that our free cash flow was $2.3 billion; that means that free cash flow per share was more than $9.

Of that amount, we distributed that $7.30 per share through share repurchases and dividends, or 80% of free cash flow.

Based on our average 2012 share price of $63.63, our cash yield was 14.3%, and in 2012, our shares appreciated 15.5%.

As you can see from the guidance, we expect another strong year of cash generation and we expect to continue our balanced cash deployment strategy that returns a substantial amount of cash to our shareholders.

Turning to results for the sectors, Aerospace Systems finished the year on a high note with a 7% increase in fourth-quarter sales and slightly higher sales for the year.

AS margin rates for the quarter were outstanding at 13.8%, and margin rate of 12.2% for the year matched last year's strong performance.

AS did book a couple of positive performance adjustments in the quarter and at space programs, neither of which was more than $20 million.

For 2013, we expect AS sales of approximately $9.7 billion, with a margin rate of low- to mid-11%.

The sales trend reflects lower volumes for space programs, Joint STARS and the F-18, which is more than offsetting higher volume for unmanned programs due to the ramp up of NATO AGS and Fire Scout.

Electronic Systems also had outstanding results.

While fourth-quarter and full-year sales experienced a mid-single digit decline, operating margin rate increased 28% for the quarter and 11% for the year.

Margin rate was outstanding at 18.5% for the quarter and 17.1% for the year, records for both periods.

ES fourth-quarter net performance adjustments were about $50 million higher than last year, reflecting solid operational performance, as well as a lower level of negative adjustments for contractual issues.

The fourth quarter of 2011 also included some costs for reductions in force.

For 2012, ES operating income includes an increase of approximately $160 million in net positive performance adjustments.

The increase is driven by two factors.

First, last year's negative adjustments included about $50 million in our domestic postal automation business that obviously didn't occur this year.

And secondly, in 2012 we had a higher level of favorable adjustments, particularly for combat avionics, as well as at several programs completed deliveries, negotiated contract modifications, or successfully mitigated risk.

For 2013, we expect ES revenues will be roughly comparable to 2012 levels at approximately $6.9 billion.

This does contemplate lower volume for some space programs, some continued impact from force reductions in our overseas contingency operations, partially offset by higher international sales.

We do expect continued strong margins, but obviously, some of the 2012 performance improvement is likely not sustainable.

We expect ES operating margin rates of low- to mid-14% for 2013, and while not at the record levels of 2012, they are still very healthy and indicative of outstanding execution at Electronics Systems.

Turning to Information Systems, fourth quarter sales declined by 2%, principally due to the divestiture at Park Air Norway in the second quarter of this year.

Park Air contributed $30 million in sales in last year's fourth quarter.

For 2012, IS sales declined by 7%.

For the year, the divestiture of Park Air Norway and the County of San Diego IT outsourcing contract reduced sales by $100 million, and the JTRS termination accounted for about another $80 million of the variance.

After these items, IS sales decline was [approx] 5% and reflects forced reductions in overseas contingency operations and the wind-down and completion of a variety of programs.

IS operating income reflects lower volume and improved performance.

Fourth-quarter margin rates do reflect the impact of some costs related to affordability initiatives, but for the year, margin rate expanded 60 basis points at 10.3% -- outstanding performance, particularly in light of the lower volume in a challenging market environment.

For 2013, we expect IS sales of approximately $6.7 billion.

I want to point out that about $125 million of that variance to 2012 sales reflects some portfolio shaping activities, as well as the transfer of inter-company efforts to our corporate shared services organization.

That transfer, which is about $100 million of the $125 million, does not impact overall Company P&L -- as you know, inter-company sales are eliminated -- but will impact the year-over-year comparison for IS.

Excluding these items, we expect the decline of about 7% due to lower volume for in-theater programs like BACN, Command Post Platform and C-RAM, to name a few; some wind down or completion on a variety of other programs, and the expected impacts of the current CR.

Moving to Technical Services, fourth-quarter and 2012 sales declined 7% and 5%, respectively.

Trends in both periods reflect our portfolio shaping actions to reduce base and range operations volume, some lower KC-10 volume, and the ICBM program restructuring.

Operating income for the fourth quarter is consistent with the change in volume; and for the year, the higher income and margin rate are due to improved performance on the KC-10 program.

For 2013, we expect TS sales of approximately $2.7 billion, which contemplates the impact of the current continuing resolution, some force reductions in the ICBM program restructuring, and then a little bit of portfolio shaping, as well.

We expect the mid- to high-8% range and margin rate for TS in 2013.

And I know many of you know this, but I would point out that our IS and TS Businesses are our shortest cycle Businesses and most vulnerable to the uncertainty of the current budget environment.

As I said, our segment operating margin rate for 2012 was 12.6%.

You will see when we file our 10-K that we had net favorable performance adjustments of $985 million for this year.

That includes an increase of about $150 million in favorable adjustments, and about $100 million decrease in unfavorable adjustments.

Much of the increase in net favorable adjustments occurred at ES, and I don't expect that to recur this year.

So on a consolidated basis, we expect segment margin rate in the low to mid 11% range.

Turning to pension costs for 2013, the assumptions that underlie our 2013 net FAS/CAS pension adjustment of $120 million include a discount rate of 4.12% versus last year's 5.03%; a long-term expected rate of return of 8% versus 8.25% last year; and reflect 2012 investment returns slightly lower than 12%.

We expect 2013 FAS of approximately $380 million, which is about equal to the 2012 amounts; and we expect our CAS costs of approximately $500 million.

That CAS amount could move up or down by about $30 million, depending upon the outcome of our annual demographic study, which we expect to complete in the third quarter of 2013.

So after pension costs and corporate and allocated expenses, we would expect our total operating margin rate will range between high-10%s and low-11% for 2013.

We also expect a tax rate of about 33%; that includes the positive impact of the extension of the 2012 and 2013 R&D credit, which we estimate at about $27 million or about $0.10 or $0.11 for 2013.

The 2012 credit, about $15 million, will be recorded in the first quarter of this year.

Earnings from continuing operations are expected to range from $6.85 to $7.15 per share, which assumes a weighted average share count reduction of approximately 7%, reflecting continued share repurchases in 2013.

Cash from operations of $2.1 billion to $2.4 billion, and free cash flow of $1.7 billion to $2.0 billion, before the after-tax impact of the discretionary pension contributions.

We did make progress in 2013 in reducing the seasonality of our cash flow, but I still expect cash flow to be weighted towards the second half of the year.

We do plan at this point a $500 million discretionary contribution in 2013, over and above our required contributions, which are less than $100 million for this year.

Beyond 2013, we would expect CAS harmonization will begin to increase CAS pension recoveries in 2014 and 2015.

And over that same period, our annual pension contributions -- required pension contributions -- should be about a little bit less than $100 million, which is principally for our non-qualified plans and some of our foreign plans.

In summary, continued strong operating performance, strong cash flows for our Businesses in 2013.

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

Thanks, Jim.

As a reminder, each participant should limit themselves to one question and a single one-part follow-up question.

Frances, we are ready to begin the Q&A.

Thank you.

(Operator Instructions)

Our first question will come from the line of Jason Gursky.

You may proceed.

Good morning, Jason.

Good morning, everyone.

Thanks for taking the question.

I'm wondering if you might just give us a bit of an update on the long-term margin targets, and whether you have seen any change here as you move into the new year.

Yes, we set those targets a number of years ago by looking at the performance of our peers over a long period of time, and we use them to incentivize our organization to improve or drive performance.

It's worked really well.

I tend to think of those not necessarily as targets, if you will, but more of a benchmark on what our businesses ought to generate over a long period of time.

We continue to strive to do better than those, quote, targets or benchmarks; we have done better than that.

We've been very successful in using them as a motivation for our team to do better, and I continue to believe that they are applicable, as I said, over a long period of time.

Looking at the performance that we and our peers have generated during that period of time.

I find that they tend to be supported by many of our major peers, as well.

So I -- all in all, I think they have served us well.

They continue to be that benchmark that we refer to but strive to do much better.

As I said, we continue to incent our team to drive performance and it really has been beneficial in doing that, so I'm comfortable with them as they are.

Okay, that's great.

Then the follow-up question is just a book-to-bill outlook as we move into 2013 and how that translates into revenue stream as we move out.

Jason, it's Wes.

You know I think we all recognize that this year, with the continuing resolution that we have in place, much less some of the uncertainties that we see as potentials on the horizon, that book-to-bill is going to be under pressure, and getting to a 1 book-to-bill would be a tremendous outcome.

We don't guide on book-to-bill or awards each year, but I would say anything close to 1 for 2013 would be a great outcome.

Okay, great.

Thank you, guys.

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

You may proceed.

Good morning.

Hi, Doug.

I'm interested, Wes, you talked about some of the success you've had in cost reduction, square footage, head count, over the past couple of years.

And when you sit today and look at the opportunity going forward for the next year and say, the following year, does it look like the opportunities are as large today as you saw in the past?

You know, Doug, it really depends on the business base that we see on the horizon, and all of that sort of depends on some of these budgetary decisions that get made.

To the extent that there are more severe budgetary outcomes than the President's FY '13 budget would suggest, then, yes, there's a -- it will go with that.

We will need to continue to scale the operations and continue to address whatever comes our way; I think we've shown we know how to do that.

It's something we would rather not do in terms of dealing with a more severely depressed budget than the Pentagon is already trying to manage its way through, but we do certainly have the capacity and know-how to get that done.

If things were pretty much on-track for the budget, just from my perspective, there's always room for more, and we're going to continue to push and drive efficiency in our corporation.

I'm not going to set any public targets on how much more we can get.

But I think I would just say that the market should be informed by the work that we've been doing, that we are determined at ensuring that we can be very, very competitive from a cost structure perspective, and that goes to every aspect of cost.

And that we can be putting forward the most affordable concepts and approaches for our customers who are dealing in a much more tightly constrained environment.

So it really is a responsibility that we see to support our customers to be as cost efficient as possible.

Well, and then on the continuing resolution, certainly, with the CR in place, that limits the availability of funds for new starts, for transitions from development into production often.

When you look across your portfolio, where are the areas or the major programs that you are most concerned about in terms of being able to ramp up or make the transitions?

You know, Doug, it touches every one of our sectors in some way, in the large sort of hardware-oriented parts of our business.

We have a whole variety of programs that are undergoing that transition.

Whether it's unmanned systems like BAMS, even things that are at the very early stages of development, where you want to go out and do long lead associated with production.

Those -- it would be too long a list to go through; I mean, they are all touched in some way.

Then clearly, the shorter cycle businesses, both information systems and technical services, deal with this at a much higher rate because the nature of a short cycle business is you've got to start the new programs more frequently.

And when you're constrained in your ability to do that, it really hamstrings the customer community and us from doing that in the most efficient way.

Ultimately, what you end up seeing happen in those types of businesses, our current programs or services approach get strung out and while that can be good in some respects, ultimately, that's usually not the best answer for the customer either.

So I hate to give you too general of an answer to that question, but the detailed answer would be incredibly detailed in that we see this environment, with those types of very tight restrictions, really touching all the components of the business.

And I think that's why you're hearing -- well, it's one of the many reasons why you're hearing the Department be so vocal about this CR approach and how constraining it is.

And they are attempting to be very clear with the Hill that resolving these restrictions as we come to the end of March and the current CR expires, is a necessity for them to be able to really operate the Department in a more efficient manner.

If we're talking about saving money for the government, efficiency matters, and so that's a critical message.

Okay, thank you.

Thanks, Doug.

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

You may proceed.

Hey, good morning, guys.

Hi Carter.

Just, Wes, I know this is a hard topic to address and in terms of contingency planning, if we actually do trigger the sequestering.

Obviously, you have a set of contingency plans that you will work off of.

I wondered if you might kind of take us through, what's the sequence of internal events if something like that is triggered?

What's the sort of play-by-play of the implementation of one of those plans?

You know, the work that we've been doing to get ready for the variety of scenarios is both broad and deep.

And I guess I should start just by saying, so that I'm clear about this, I'm not going to speculate on what scenario might lie in front of us, whether it's sequestration or problems associated with the CR that I was referencing in relation to Doug's question.

There's clearly a lot of uncertainty on how this whole situation is going to get addressed, and the fact that we're now seeing instructions from the OMB and the DoD to the federal agencies and the services, respectively, regarding steps to be taken in preparation for sequestration being triggered on March 1st indicate an increased seriousness in the approach to a potential sequestration.

In the event of sequestration or other budgetary actions, our first challenge is going to be addressing whatever contractual changes come along.

But ultimately, we have to scale our cost structure, and that's what our planning has been focused on.

To enable us to do that in a smart way, so that we're not doing something that undermines our ability to perform for the long-term.

But we've worked our way through those scenarios and are prepared to respond to a variety of potential outcomes that may come into play.

But the other thing that I think is really important to point out here, and sometimes gets lost a little bit in some of this dialogue, is our primary obligation is to successfully execute on the portfolio contracts that we've taken on.

And so the planning work that we're doing is trying to be mindful of what might happen, but also, has as its primary objective do no harm, to make sure that we really can and do continue to execute really, really well.

When we think about all of these different scenarios, I think to the question you're asking, we have to think about it in terms of contractual -- potential contractual actions that our customers would take.

And traditionally, that's what would trigger any particular sequence of events on our side, whether it's delay in terms of slowing a contract down, or in a more ugly situation, termination for convenience on the part of the customer.

Naturally, as a part of our process, we are -- we have gone through our full set of contracts and we understand what the issues and approaches would be associated with those variety of potential customer actions.

And they all vary by scenario and we're certainly prepared to address those if we have to.

In general, as I was remarking earlier to Doug's comment, it adds cost.

It adds cost to the Department to have to go through and do those things in a period of time when the nation is trying to minimize outlays.

The idea of adding cost is not a really good idea, and what's interesting to me is I don't see folks on the Hill adding up the numbers that go with all those additional costs that will get created by that massive inefficiency that would result.

The other part of the planning process that's also very important is the people part of this.

This isn't just about contracts; contracts turn into work that real people perform, and these are individuals whose skills are precious resources in our country.

These are the skills that enable the companies in the defense industrial base to provide the technological superiority upon which our nation's strategy -- our national security strategy relies.

And so part of our challenge, as we think our way through this, is being ready to address how we most diligently and carefully manage that precious resource of capability.

That we're going to need to make sure that we preserve our ability to continue to support the nation as we go through this challenge, and I would say that, in my mind, is the most challenging part of this.

We're talking about extraordinarily good people who have lots of opportunities, and making sure that they see our industry as a great place to continue their careers, despite these budgetary pressures.

That's something we are all working hard on because we know that ultimately, that determines the success of our ability to support the mission that we're here to serve.

Thanks, Wes.

I'll skip the follow-up so somebody else can ask.

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

You may proceed.

Yes, thanks so much, and great quarter.

So I think on the third-quarter call, you mentioned the F-35 was going to be, I think higher volume in the second half.

Could you give us some sense in terms of where the F-35 volume was last year?

Where should it be in 2013?

How is your performance, and what's the opportunity for improved profitability at some point?

Cai, from memory, the F-35 this year was around $1 billion in terms of revenue and about $1 billion would be the expectation for next year, as well.

You know we don't comment on profitability by individual programs, so I'm really not going to go there.

We are working hard to be a teammate with our friends at Lockheed and support the program.

We're doing well in our pieces of the work and I would characterize our margins at this point as basically as I would expect, given the stage of the program.

So the follow-up would be if we look at Aerospace, you kind of have lower margins projected and some mature stuff coming off.

When do we have some of these newer programs like the F-35 reach the point where they should start maturing so those margins in aerospace could start to improve?

On the F-35, I don't really see a step-up in terms of volume until about 2016.

Given that the current plan for quantities.

Okay, but I mean the question was volume.

As you mature the program, and you made the point about where you are in the stage of the program, usually the margins get a bit better.

So when do we reach the point when more of that volume starts to become mature?

If we want to talk about aerospace in total, we still have a very good, strong mix of new development-type programs.

And I don't think that changes much over that couple-year period of time going forward.

Okay.

So the good news is continued growth on new opportunities would be important as that portfolio transitions over time.

Okay, thank you very much.

Thanks, Cai.

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

You may proceed.

Good morning, Sam.

Good morning.

Wanted to talk a little bit about ES, in that Jim, you had mentioned about the net favorable adjustments this year and that they were the majority of the total.

If I back those out, it's -- and I don't know exactly what the total favorable adjustments are, but it would still seem to imply a margin well into the high- 14s on a baseline, and your guidance seems to imply 50 basis points below that.

So I'm wondering, why is it declining even ex-adjustments in 2013 versus 2012?

I thought you were going to ask me why they are above long-term rate of returns or something.

(laughter) No, that's not a new question.

I think that the team at ES is just doing a fabulous job over the last few years.

They really have driven up the margins.

We have worked really hard to reduce the negative adjustments that part of that business has been plagued by over -- looking back three or four years or so.

And at low to mid-14%, I think they are going to just have a great year.

So there's not really a change in the mix or development to production or anything else that's going to drive it?

I don't think so.

We do have -- did have, in 2012, a number of programs or contracts reach the end of their production or life, and we did get a benefit from the cost reduction activities that we undertook at ES and at the Company in '11 which in '12 had a big impact, or favorable impact on their contracts.

And as you know, you give those up as you go forward with new contracts, so all of those are factors into that overall margin rate expectation for ES for 2013.

Having said that, you bet we're going to push to get at the very best performance that we can out of that part of the business and every other part of the business.

Jim, I would just add that similar to your earlier remarks around aerospace, ES has been very successful these last couple of years in capturing some new development work, as well.

Sure.

And as you all know, the margin rates during the development cycle are generally less, and I think we'll see some of that, too.

And we have some new development activities, possibilities.

Exactly.

It's on the horizon here.

Okay, thank you very much.

And your next question will come from the line of Rob Stallard from Royal Bank of Canada.

You may proceed.

Good morning.

Good morning, Rob.

Hi, Rob.

Just a quick one; Jim, actually.

I was looking at the goodwill on the balance sheet; you've got $2.4 billion.

I was wondering if you did your annual impairment review, what the results of that were?

How much cushion you might have from the latest reassessment at goodwill?

You bet we did our annual impairment test, and just like last year, the most sensitive piece of our business is IS, and we have -- we do have a cushion.

It's not real large, if you want to call it that or look at it from that perspective, but we're comfortable with where we are at the end of the year.

And as we go forward, we'll do the test again based on new information when we have it.

And I'm sure you weren't able to get into specific details, but can you give us an idea of maybe how much that cushion might have reduced versus last year?

Yes, it's down a little bit from last year, but -- and frankly, the cushion is a combination of a whole bunch of different factors.

Obviously, interest rates play into the discount rate on the used discount cash flows, it has an impact on terminal value, has an impact on pension liability.

All of those are factors in the overall calculation.

But it does start with the expected cash flows from the business, and our guys at IS, although revenues are down, we still expect that they will have reasonably healthy margins, given our guidance for this year -- for 2013 and, again, comfortable with where we are.

Yes, and then just a quick one for you, Wes.

I was wondering if you could maybe comment on the competitive environment that you are seeing, and your ability to preserve margins going forward.

Yes, I think a lot of that goes back to the point I was making earlier around affordability.

Clearly, as the Department's budgets are under increasing pressure, our customer community needs our industrial base to drive additional efficiencies into the way that we do business, which we've been busily doing now for several years.

And they need good ideas; they need the innovation that can come out of our industry to suggest alternative approaches to getting things done.

So I think -- just thinking about it very broadly, the competitive environment is going to be very healthy.

I think everyone's working on costs and everyone's working on innovation, and hopefully, we're all going to be able to not only be competitive with each other, but be supportive of our customers in this more difficult period of time.

It is going to be a challenging competitive environment; I don't want to sound dismissive of that at all.

Those of us who have been through defense downturns in the past have that experience under our belt, and understand very clearly what that means.

But that's part of the reason we've been doing the work we've been doing to get ready for this.

Okay, thank you very much.

Your next question comes from the line of Myles Walton from Deutsche Bank.

You may proceed.

Thanks.

Good afternoon, guys.

Hi, Miles.

How are you doing?

The first question is more of a clarification.

Jim, I think in the slides, it implies what the share -- the diluted share count benefit is, CPS, about 6% draw down.

I don't have the period-end share counts -- I don't exactly, but is the share repurchase number on a dollar basis about --

Myles, it's 7% on a weighted average shares.

Yep.

This year to next year.

Is the dollar repurchase assumed to be about the same?

Yes, roughly the same.

Obviously, for planning purposes, we've assumed that it's generally proportionate throughout the year, which equates to about a little bit more, actually.

Price-dependent, obviously.

Yes.

No, that kind of brings to the question, so your -- to your earlier comments on your pension plan, you are in a much better funding position than probably anyone else, or definitely better than anyone else out there, probably 85% or so funded.

Actually 83, you'll see in the K.

83, all right.

So if I look at your cash balance, it continues to grow.

You're returning 80% of the free cash flow generated in 2012, but again, the cash balance continues to grow.

You're in a net cash or close to net cash or zero net debt position.

At what point do you actually take some of the cash balances and return those, or at least increase more than 100% free cash flow return to shareholders?

Or is there M&A out there on the horizon that you would like to retain it for?

Well, actually, if you think about the comments that we just went through pro rata a little bit more than last year, dividends and our free cash flow guidance for 2013, you're at 100%, if not maybe more than 100%, just with that.

Yes, Myles, I'll just add we continue to see share repurchases as a very important part of our overall balanced cash deployment strategy.

We think that it has been serving our shareholders well and it has been a good use of our cash.

We do think about our business over the longer cycle, and that's the perspective that we have in mind when we're thinking about our approach in share repurchase, in particular.

So it continues to be a very attractive mechanism for cash deployment for us.

Okay.

So the cash balance, though, question, you would still expect it to be not coming down any time soon, in terms of this being the level that you would be comfortable maintaining on the balance sheet?

$1.7 billion to $2 billion on free cash flow, let's call that a midpoint of $1.8 billion or something like that.

$500 million for dividends, round numbers.

If I have a similar amount of share repurchases to last year's, that's $1.8 billion, midpoint of that free cash flow; got CapEx, free cash flow is out of that.

But then if I spend any money at all on things like funding the pension plan or other opportunities, and clearly, as we have tried to outline, we're in an uncertain environment, so we do want some financial flexibility to be able to deal with that.

I think I'm -- on one hand, I'm continuing to do what we set out to do and have done over the last few years with deploying cash to invest in the business, to manage our pension plans and return excess cash to shareholders.

And provide us with financial flexibility to deal with this uncertain fiscal environment that we're in at this point in time.

Okay, that's fair.

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

You may proceed.

Yes, good afternoon.

Your level of EACs that you've assumed in your 2013 guidance is what?

Less than last year.

Okay.

Any -- obviously, last year was close to $1 billion was pretty high.

Any sort of range?

No, I really think about it as overall margin rates as opposed to what kind of level of adjustments do I need to have to get there.

Okay.

Jim, on the cash flow from ops walk, can you give us some help on working capital, cash taxes, what's baked into that number relative to 2012?

Sure.

Yes, as you all know, the hardest part in this business on cash flow projection is working capital.

So right now, the guidance anticipates a use of working capital anywhere from, let's call it $50 million to $250 million for the year.

Cash taxes and tax expense, roughly about the same, maybe $50 million greater on cash taxes.

And then the other variable in that whole range of EBITDA to free cash flow is, first of all, stock compensation, about $100 million, and then CapEx are around $400 million for the year.

Great.

And then last one, you -- if I'm looking at it correctly, you still have a decent chunk of what would be considered relatively high cost debt outstanding, given today's rate environment.

What's the plan, if anything, to address that?

I know other companies have gone after that pretty aggressively.

We tendered for all of that, or much of that in 2010.

We actually tendered for $1.9 billion at the time, and we were able to pry out about $800 million.

We continue to look at it, continue to look at who holds it and the likelihood that they might be receptive to tenders.

At this point, we haven't been able to convince ourselves that something like that makes sense, given who the holders are of that largely high coupon debt.

Okay.

Thanks a lot.

Your next question is from the line of George Shapiro from Shapiro Research.

You may proceed.

Good morning.

Good morning, George.

I wanted to ask, you were surprising to me in the sense that you had substantially up margins, where a couple of your major competitors had down margins in the quarter.

But yet you're still guiding to a significantly lower margin in '13.

And even though you've always been conservative in the past, I am just wondering, is it all just EACs reflective against '13 or the core programs are that much tougher?

If you could just go through that a little bit more.

Well, I would say that we have an increasingly tougher environment.

At the same time, we're working very hard to make sure that on all of the new contracts, we get reasonable terms and conditions, that our cost estimates fairly reflect what we think our costs are to do the work.

As I did mention earlier, we tried to get out ahead of what we saw as a decline starting in 2011.

We did take a number of actions to reduce our -- as Wes said, our footprint and our head count.

We did get a benefit in 2012 on our backlog, for those activities.

Our backlog normally runs about 1.5 years.

If you get all the benefit on 1.5 years, you got a year's worth in '12, you don't have a whole lot left, do you?

So it's a combination of just what we see in the marketplace in terms of the environment and the actions we've taken that have resulted in favorable performance adjustments.

As I said, we have also worked very hard to reduce the quantity and the quantum of any of our problem programs and been, I think, pretty successful at that.

So it's really just that look at the entire portfolio of programs and where we stand that lead to our judgment around those margin rates for 2013.

Which, I think, are really strong operating performance, particularly in light of our benchmarks for the types of businesses we are in.

Which, as I said, largely are confirmed by many of our peers, both in their guidance for this year, as well as their performance.

So all in all, I think we're doing a pretty good job.

No, you definitely are.

And just a follow-up for either you or Wes.

So, Wes, you clearly have done a great job in taking out costs before, ahead of revenues.

Can you continue to do that, if sequestration goes into place, which is going to be somewhat more abrupt?

I mean, how do you actually plan to be able to do that or continue that?

Yes, George, I remarked on this just a little bit earlier that in the event of sequestration or other budgetary actions, our first challenge is going to be addressing whatever contractual changes come along.

But ultimately, we have to scale cost structure where we're at, and that's what our planning has been focused on.

To enable us to do that in a smart way, so that we're not doing something that undermines our ability to perform for the long-term.

But we've worked our way through those scenarios and are certainly ready to take on the variety of scenarios.

Ultimately, though, in any of those outcomes, first and foremost, we're going to have to deal with the contractual matters.

Okay.

Thanks very much.

Thanks, George.

Your next question comes from the line of Yair Reiner from Oppenheimer.

You may proceed.

Thank you.

Congrats on a very strong quarter.

Thanks.

The question about free cash flow after discretionary pension.

They have been fairly volatile here over the last couple of years, $1.9 billion a couple years ago, now just $2.3 billion in 2012, and I guess the guidance for 2013 implies somewhere between $1.2 billion and $1.5 billion.

Now, I understand that a lot of these discretionary pension payments are going to come back to you later on.

But can you just help us understand what we should think about as a long-term, sustainable free cash flow, after pension?

Thank you.

Yes, I've said a number of times publicly that I think even in this environment, we're going to have relatively strong free cash flows as we look forward.

I really don't see -- you know, we've had strong cash flows.

I continue to expect that we will have those relatively strong cash flows, free cash flows on a go-forward basis.

I don't know what else to tell you there.

When we look at the voluntary pension amounts on a year-by-year basis, depending on what's going on in the marketplace and the economic benefit that we see by making those contributions.

So that is something that we do look at and make decisions based on the environment.

And a look to the longer term, as well.

Thank you.

Thank you.

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

You may proceed.

Thanks.

Good afternoon.

Hey, Joe.

Your backlog went up, both funded and overall, this past year, and you have revenue guidance that's down without sequestration.

And I was wondering if you could comment on whether that's just a profile of the backlog, the tail got bigger, or if there's something else in your planning.

And also, you had a good quarter from a sales standpoint, I might add, the best one you've had in a while.

Joe, backlog is a function of obviously, contracts and the performance of contracts.

A contributor to our backlog this year is the NATO AGS contract.

It extends over five years or so, so when you get a contract like that, it adds to your overall backlog numbers, as well as the period of performance that goes with that.

So that's principally the factor that you're seeing that's contributing to growth in backlog dollars, and you perform those contracts, as I said, over about a five-year period of time.

So it's just AGS?

NATO AGS.

Joe, in my earlier commentary, I went through the components of the -- of about the roughly $1 billion differential in sales.

So I don't know if you caught that commentary, but it might be helpful in addressing your question, as well.

Okay, thank you.

The next one, the second one is just we're all focused right here on the sequestration and the CR and everything.

Wes, when you look out a little further, not even that much further, you have this Next Gen Jammer competition.

Could you comment on that, and your teaming arrangement there with Excellus -- and what led you down that path?

And then really, any other competitive situations that you see over the next year or two for the Company that you consider important?

You know, there's a whole variety of activities that we're pursuing.

And I liked your perspective on it, that we all do need to keep looking down the road because the nation is going to continue to need a defense industrial base, and we're going to continue to need that technological superiority that the industrial base provides.

Next Generation Jammer is an exciting opportunity; we have been working on that now for some time.

Our teaming with Excellus was driven by a view of, how do we bring the very best offering to our customer?

And we saw in the team at Excellus some great capability, that when combined with ours, we believe is a compelling offer, so that relationship is going well and I'm looking forward to continuing it.

There are a whole series of opportunities of that nature and some even larger scale, as we look on the horizon.

Clearly, both the Air Force and the Navy, and I would add to that, the intelligence community, really need to position their capabilities to align with the nation's evolving national security strategy.

This pivot to Asia-Pacific has broad implications on the types of capabilities that are going to be needed, that range from aircraft, unmanned and manned, they range to sensor systems, the C-4ISR domain.

And also cyber continues to be a heck of a challenge for our country, and we think it is going to continue to be a challenge.

Across that array of broad missionaries, there are a whole array of specific programmatic targets, both '13 and '14, that we are investing in and continuing to push hard on.

And the one point I would make in response to your question, that even while we're seeing perhaps tougher environment around the top lines, we're committed to continuing to invest for the future here.

We think that -- we feel very strongly that it's going to be imperative, that the defense industrial base continue to bring innovation to the nation's capabilities, and investing now is going to be important for our ability to serve for the long-term.

Wes, are you seeing the procurements groups at your classified customers having the same sort of freezing up at the same sort of issues that the broader customer set is going through right now?

Or have there been more provisions for -- to enable them to operate more smoothly through this whole situation?

Joe, there's only so much I can say about that, but I will say that they, too, are subject to the legislation around the CR and potentially, if we were to get to the sequester of those issues, as well.

So they are having to address that in a very prudent manner and address it from a planning perspective, as well.

So these budgetary effects sometimes just get a stamp on it associated with the Department of Defense, but they hit everybody.

And I think it's important to understand that from a broad policy-making perspective, that this really does span across government, all the functions of government.

I think we have time for one more.

And that last question will come from the line of Howard Rubel from Jefferies.

You may proceed.

Well, thank you very much.

Kind of two parts.

Wes, the interesting thing about all that's gone on is the Authorization bill protecting the Global Hawk in a big way and actually underscored how important it was.

Can you address some of the other positives that came out of that?

And how do you square that walk with Congress' will there with -- in fact this meat axe approach to solving a problem that doesn't?

Yes, it's hard to square that, Howard.

I appreciate your question.

You know, it's clear to us that when Congress, and particularly those in Congress who are charged with addressing specific matters associated with the functioning of our government.

When they are given the latitude to dig in and really address a particular issue, they are able to do that strategically and they are able to make great decisions.

When there is this broad umbrella approach to trying to deal with bigger challenges without dealing with the strategy, you get to these other approaches that really don't make sense from a strategic perspective.

On Block 30, I would just say that we continue to be pleased with the performance and theater of those systems.

They are in very high demand by the combatant commanders.

We were just delighted to see the Authorization Act support the continuing of Block 30.

We continue to work with the Air Force to provide more affordable approaches to sustaining that program because we think that will be something that's going to be important to the country's ability to conduct a surveillance mission for a long time.

So I would just say it's sort of the contrast between the processes.

When the Congressional processes that have been developed over many years to work on and deal with the authorization and appropriations for specific components in government are allowed to do their jobs, I think we get to very good rational outcomes.

When there is this broad, across the board meat axe approach, we get to really bad outcomes.

And then just last, just a follow up.

The numbers would say you don't have very many red programs or anything close to them, but I'm sure there's always you're not happy with.

How would you evaluate, maybe the bottom 10% of your performers at the moment, and what are you trying to do to change that?

Yes, we have been doing a lot of work on that over the last few years.

Jim alluded earlier to the fact that it wasn't that long ago, four or so years ago, that we had a serious list of red programs that we kept talking to you all about, seemed like every quarter.

And so the focus on performance in our Company is not just about margin rates.

It goes to performance for our customers, as well.

It starts with quality; it starts with the quality of our processes and the quality of how we approach getting the work done, and I'm not just talking about the quality coming out the end of the production line.

It's the quality of engineering, it's the quality of contracting, it's all of those aspects.

So we're not perfect; I wouldn't want anybody to hear that we think we are somehow reaching a point of perfection in any way.

We have still a lot of work to do, as any honest organization would tell you.

But we have substantially reduced the number of programs in our portfolio that are demonstrating those performance variations, in part, because I think we have made good progress on our risk management methodologies.

And for those programs that are in the bottom 10%, I would characterize them as those where the risk that we've identified and been working to manage still find a way to manifest in some way.

But we're able to get on them more quickly and more aggressively, and we're -- we have become a lot better about utilizing the resources of the entire corporation to go after them when those problems pop up.

So still work to do.

Still, I think to some extent, inevitable in the technologically complex environment in which we operate, but a lot better place than we were a few years ago.

Thanks, Wes.

Thanks, Howard.

This concludes the Q&A session.

I would like to turn it over to Jim for a couple of brief comments on some information that's always of interest to you all, and then turn it over to Wes for final comments.

Yes, I'm kind of disappointed I didn't get my normal FAS/CAS pension question.

Let me try to answer what I would have anticipated to be your questions.

We talked about our FAS and CAS guidance for 2013.

And if I look forward to, let's say, 2015, two years out, I would expect based on no change in our assumptions, that our FAS costs would decline about $130 million and that CAS cost would increase about $300 million, or the net FAS/CAS change being about $430 million.

2014 is probably halfway in between the 2013 numbers and the 2015 numbers.

I spent some time this morning talking about the current environment, the possibility that we're faced with at least an uncertain defense budget and likely, a declining defense budget.

So clearly, in that environment, the emphasis on affordability is so important.

So growth in CAS cost isn't necessarily good, because it does add to the affordability challenge that we all face in light of that environment.

So we are working really hard to reduce both FAS and CAS costs.

And if we find ourselves in a rising interest rate environment, as you know, from our past conversations, that rising interest rate has a near-term impact on our FAS costs.

And we would look at that today as being every 25 basis points is in the range of $85 million to $90 million.

However, because of Map 21, a rising interest rate environment over the near term likely doesn't have nearly the impact on CAS as it does on FAS, and on funding.

Ultimately, besides rising interest rates over a long-term, the important lever for reducing or controlling CAS costs, as well as funding, is [first of all] investment performance.

Our 10-year compound annual rate of return is just under 10%.

Then you have to manage the provisions of your plans.

We capped entrance to the pension plan back in 2008, as I recall, so any new employees do not have the same pension benefits as in the past.

Last year, we announced another change for our pension plans that essentially capped the growth in compensation costs, all of which are aimed at reducing CAS cost on a go-forward basis.

So we've been working really hard, and I know you all are interested in those trends around FAS and CAS, so I wanted to give you that flavor as you work your models.

But this is going to be an important item as we go forward.

So, Wes, with that, I think we're ready to close.

Thanks, Jim and Steve.

Let me just wrap up with a couple of thank you's.

First, thank you to our employees for their incredible focus on performance and serving our customers.

Our 2012 outcomes are due to the hard work of our team and we all sincerely appreciate that.

And secondly, thanks to all of you for your continuing interest in our Company.

We appreciate you being with us on the call today.

Thanks, everyone.

And ladies and gentlemen, this concludes your presentation.

You may now disconnect.