諾斯洛普·格拉曼 (NOC) 2013 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Northrop Grumman's first quarter 2013 conference call.

My name is Sheverly and I will be your operator today.

At this time all participants are in listen only mode.

(Operator Instructions)

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

Mr. Movius, please proceed.

Thanks, Sheverly, and welcome to Northrop Grumman's first quarter 2013 conference call.

We do not have a PowerPoint presentation for the first quarter; however, we are posting an updated Company overview that provides supplemental information on our four sectors.

You can access our new Company overview at www.northropgrumman.com.

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

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

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

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

At this time, I'd like to turn the call over to Wes.

Thanks, Steve.

Good afternoon, everyone, and thanks for joining us.

Our first quarter performance demonstrates that our team's focus on affordability, cost competitiveness and program performance continues to generate solid results.

This was another good quarter, and I'm very proud of the track record that our team has built.

Despite slightly lower sales, first quarter earnings per share increased 4% to $2.03.

The combination of strong operating performance from all four of our businesses and share repurchases drove this quarters EPS growth.

Our first quarter sales declined by approximately $100 million, or 1.5%.

Sales for our short cycle businesses, Information Systems and Technical Services declined by approximately $200 million, which was partially offset by a $100 million sales increase at Aerospace Systems, our longest cycle business.

Jim will discuss trends within each sector but, generally speaking, top line pressure in our short cycle businesses reflects federal budget turmoil, continuing in-theatre force reductions and our own portfolio shaping actions.

Information Systems was most impacted by the pervasive budget uncertainty in the first quarter and the restrictive nature of the continuing resolution that expired on March 27.

Segment operating margin rate was strong at 12.3%, and we reduced our year-over-year weighted average shares outstanding by 7%.

During the quarter we repurchased 6.5 million shares of our stock for approximately $431 million.

At the end of the first quarter, approximately $1 billion remained on our share repurchase authorization.

First quarter cash from operations improved year-over-year and free cash flow improved by approximately $150 million.

We ended the quarter with a total backlog of $39.4 billion, which reflects new awards of $4.7 billion, or a 77% book-to-bill.

First quarter book-to-bill was impacted by our customers reluctance or inability to award contracts or task orders.

Sequestration and the restrictive CR were significant overhangs, and most major contract negotiations are taking longer due to the numerous issues our customers have to address in today's environment.

During the quarter we announced several actions to insure further alignment with our customers need for increasing affordability, innovation and cost competitiveness.

We're establishing aerospace design centers of excellence in Florida, California and New York for manned and unmanned aircraft and electronic attack.

We're also establishing two aircraft integration centers of excellence in Palmdale, California and St.

Augustine, Florida.

These actions are aimed at focusing and leveraging capabilities in our key areas of manned aircraft and unmanned systems.

Taking a center of excellence approach will allow us to preserve knowledge and critical skills across a changing program base.

We're continuing to close and consolidate numerous facilities across the Company.

These actions are aimed at improving our cost competitiveness by reducing our facilities footprint and leveraging our enterprise-wide capacity in the most efficient and cost-effective manner.

Looking ahead, we now have a fiscal year 2013 appropriations bill in place.

Sequestration, of course, is now in effect and our customers are in the process of making the programmatic decisions necessary to comply with the reduced budget levels.

I'd also note that the President has submitted a fiscal year 2014 budget.

The administration's budget does not include sequestration, highlighting the importance of continuing to adequately fund our national security efforts.

However, if Congress does not take legislative action to avoid the continuation of sequestration, approximately $50 billion in additional spending reductions will be required in FY2014.

In addition to these budget considerations, Secretary Hagel's review of national defense strategy is expected at the end of May.

This review may inform additional programmatic decisions as well as the upcoming quadrennial defense review.

All of this is creating a high degree of turmoil as our customers navigate these budget cross currents.

We share the concerns of our Pentagon leadership that damage to national security may be irreversible under a prolonged sequestration.

With few exceptions, we were pleased to see that the President's fiscal year 2014 budget supported many of our largest programs.

Funding for the E-2D Advanced Hawkeye was increased 25%.

21 EA-18G Growlers were requested at roughly double last year's funding.

F-35 units were maintained and space programs like SBIRS, Advanced EHF and the James Webb Space Telescope were sufficiently funded.

We believe it is important that the budget provides $13 billion for cyber related activities.

The Department of Defense designated cyber security as a key investment area and increased funding in this area by more than 20% to $4.7 billion.

We were also pleased the budget continues to support Global Hawk Block 30 and Block 40 operations for the Air Force.

Our high altitude, long-endurance unmanned franchise continues to be well positioned in both the domestic and international markets.

Growth in our domestic efforts will be driven by the Navy's Triton program.

And on the international front, we are ramping up on NATO AGS and continuing our efforts on Germany's Euro Hawk.

Turning to our financial outlook for the remainder of the year, we're confirming the guidance we provided in January.

We now have an appropriations bill in place.

We have received some specific sequestration related program directives.

To date, these are not large amounts in the aggregate and they are being offset by more positive trends in other areas.

So without additional definitive action on specific programs, our prior guidance represents our current estimate of this year's financial results, although we recognize uncertainty remains regarding the implementation of sequestration.

While we are not yet able to determine all program specific impacts, we expect the reduced FY2013 budget levels will result in lower 2013 awards, and the related impacts to Company revenues, earnings and cash flows likely will trail the reduced awards.

We continue to expect sales of approximately $24 billion, EPS 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 billion before discretionary pension contributions.

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

Jim?

Thanks, Wes, and good afternoon, ladies and gentlemen.

My comments will focus on the first quarter results and, of course, our 2013 guidance.

As Wes said, another very solid quarter.

Our employees continue to focus on performance and execution in a very difficult and demanding environment, and I want to add my congratulations to our team for a job very well done.

Turning to the sectors, Aerospace Systems sales increased 4%, or about $100 million.

The single largest driver was higher F-35 volume.

You might recall that the F-35 program transitioned to the units-of-delivery accounting method beginning with LRIP 5. We delivered the first LRIP 5 units in last year's third quarter.

This quarter, first quarter of 2013, we had 10 LRIP 5 deliveries compared with no LRIP 5 deliveries in last year's first quarter.

AS also had higher unmanned revenues this quarter, as the NATO AGS and Fire Scout programs ramp up.

These positive trends were partially offset by a decline in space programs.

I view AS first quarter operating margin rate of 10.9% as supportive of our low to mid-11% guidance for the year and we continue to expect sales of approximately $9.7 billion for the year at AS.

Turning to Electronic Systems, first quarter sales were comparable to last year.

In-theatre force tempo reduced infrared counter measures and laser systems revenues by about $40 million.

Program completions in combat avionics and maritime systems reduce revenues by about another $60 million.

These impacts were essentially offset by higher volumes for international and space programs.

Operating income on an absolute basis was down 3% but margin rate was, again, outstanding at 17.2%.

You'll recall that in last year's first quarter we noted that ES had an unusually high level of net favorable adjustments particularly in combat avionics.

Net favorable adjustments at ES declined by $62 million this quarter, but were partially offset by the reversal of a $26 million non-programmatic risk reserve.

The remainder of the improvement reflects higher overall margin rates resulting, in part, from last year's performance improvements.

Obviously it's early in the year and most of this year's risk and opportunities are still ahead of us, but I expect that there may be some modest upside to the current guidance for ES sales and margin rate.

Information systems first quarter sales declined by 9% with the single largest item in that decline being the $25 million transfer of inter-company efforts to our enterprise shared services organization.

Before that item, sales declined by about 8% due to lower volume across a broad number of programs.

No single program accounted for a material amount of the total decline.

Operating income declined as a result of lower sales and a lower level of net favorable adjustments than in the prior year.

Although our margin rate declined, it was still strong at 10.2%.

And at this point in the year, we are maintaining our sales guidance of approximately $6.7 billion with an operating margin rate in the mid to high 9%, although there is likely some modest downside sales risks due to the uncertain impacts of sequestration on this short cycle business.

Moving to Technical Services, first quarter sales declined by 4%.

Operating income declined by 7%.

Portfolio shaping impacted sales by about $30 million and lower ICBM and KC-10 volume impacted sales by about another $40 million.

These declines were partially offset by higher volumes for new programs awarded in 2012.

Operating income reflects lower sales and an operating margin rate comparable to prior year.

We continue to expect sales of about $2.7 billion with a mid to high 8% margin rate.

First quarter segment operating margin rate on an overall basis was 12.3%, compared to 12.7% in last year's first quarter.

This reflects a $91 million decline in net favorable adjustments in the quarter.

About two-thirds of that change was at Electronic Systems but, as I noted earlier, that was partially offset by the $26 million reserve reversal.

The remaining performance improvement reflects, as I said earlier, the higher booking rates across our portfolio resulting from, at least in part, last year's EAC adjustments.

I would also note that we had a lower tax rate this quarter.

As you are aware, the American Taxpayer Relief Act reinstated the research tax credits for 2012 and 2013, so this quarter's lower effective tax rate reflects about $20 million benefit for those credits this quarter.

That amount includes the full effect of 2012 credits and one-quarter of expected 2013 credits.

Cash from operations improved by about $100 million compared to last year.

And as I think many of you know, our first quarter cash flow is typically the lowest of the year.

As Wes indicated, we are maintaining our guidance from cash from operations and free cash flow, and I would remind you that all those estimates are before the after-tax impact of any discretionary pension contributions.

And shortly after the quarter-end, we made a $500 million discretionary contribution to our pension plans.

These tax efficient contributions avoid any future funding spikes and continue to be an effective use of our cash.

I would note that over the last 10 years, our average annual plan investment returns have exceeded our long term expected rate of return by well over 100 basis points.

That superior investment performance has positively impacted our funded status, reduced future cash cost and improved affordability, and, I believe, provides a competitive advantage.

Before we move to Q&A, I'd just like to add my perspective on 2013 sales guidance.

As we said last quarter, our initial 2013 guidance did not assume sequestration and, as Wes noted, to date, sequestrated related downside sales risk haven't been that significant and have generally been in our short-cycle business.

I would characterize those reductions as pretty much consistent with our expectations in a declining budget environment.

And to date, the reductions that we have seen have been largely offset by positive trends at Electronic Systems.

So, in thinking about this, barring any specific program cancellations or terminations, we don't expect the fiscal 2014 budget debate or the results of Secretary Hagel's strategic review to significantly impact our 2013 sales.

So, given those assumptions we have maintained our 2013 sales guidance.

Steve, I think at this point we're ready to take any questions.

Thanks, Jim.

I would like each participant to limit themselves to a single, one-part question.

Also, you are welcome to reenter the queue if you have additional questions.

So, Sheverly, we are ready to begin.

(Operator Instructions)

Your first question comes from the line of Howard Rubel with Jefferies LLC.

Please proceed.

Thank you very much.

Good morning, Howard.

Wes, I want to talk for a second about UAVs.

And this is a little bit of a fine point, but the FY-13 budget approved the -- or supported Block 30 Global Hawk and the commentary outside of what Congress has appropriated would say the program has problems.

And you can see that accordingly in the FY-14 budget.

Could you sort of address -- I mean, obviously some of your commentary did -- but could you put a little bit more of a fine point on this?

If the funding is there, then won't you get it?

Yes, Howard, thanks for the question.

Let me just kind of back up and talk about Block 30 a little bit more broadly.

We continue to be pleased, and I think the customer continues to be very pleased, with the in-theatre performance of the Block 30 systems.

They are in very high demand.

They are running at a very high utilization rate.

The combatant commanders don't seem to be able to get enough of them.

So that's the sort of the operational reality of what's going on with Block 30 today.

And we're in this interesting period of time where the nation is having to make some decisions around budgets and the departments are feeling very squeezed on their ability to fit everything in and meet all of the demands of both the Congress, if you will from a budgetary perspective, as well as the operational commanders out there in the theatre.

So inevitably, there are decisions, or recommendations put forth, for budgetary consideration that the Congress has to debate and make decisions on.

And Block 30, I think, is sort of a classic example of that.

In particular, it is a brand new system and so when you do the calculation on the cost component, brand new systems take a little bit of time to work their operating cost down the curve, down the operating cost curve.

And if you're in a budgetary mode where you're trying to squeeze everything in for the next year and you're not all the way down that curve, it's easy to come up with a different conclusion.

And so that's where Congress has responsibilities to look at things both near term and long term, and we saw that in this last cycle where Congress took a view of sort of the longer term given the investment that's been made in Block 30.

So we were very pleased to see the continued support for Block 30 in the actions that Congress took with the 2013, both the authorization and the appropriations process.

But at the same time, the Air Force has real budget pressure and that's a reality that the Air Force is having to work their way through.

This turns out to be more about the cost of operating than it really does in terms of the remaining procurement.

If you look at the last of the lots of Block 30 to be put on contract, that will be Lot 11, there are really only three more aircraft in that Lot 11.

So the budget math here has to go to what it takes to sustain this system in its operations.

And so that's on us.

We have got to work with the Air Force to continue to address the cost of operating Block 30s.

We're doing that.

We're putting forward some proposal recommendations for the Air Force to consider.

But I think it's simply a reflection of this budget environment that we're in that's forcing a decision space that's perhaps more narrow than we all might want it to be given the longer term perspective of capabilities for the nation.

Thanks, Wes.

Jason Gursky with Citigroup.

Good afternoon, everyone.

Hi, Jason.

Wes, I'd like to dive a little bit deeper on the comment that you made about 2014 and the fact that the impact of sequester is kind of marginal this year, but that what we ought to be really focused on with sequester is 2014.

More importantly, that revenues and earnings are going to kind of follow the bookings rate.

So it kind of leads logically to your expectations around book-to-bill through this year and how you think that that actually translates into the trajectory as you move out into 2014, keeping in mind that you'll of course be able to continue to draw on the backlog that you already have.

But just anymore granularity that you can offer on 2014, I think would be helpful for everybody on the call.

Thanks, Jason.

I think it actually might be helpful just to step back and remind everybody of the mechanics here, because that really turns into the outcome that I think we're all trying to sort our way through.

And the analogy I would use would be how does the pig move through the snake, although in this case, I wouldn't want to impugn the population of pigs by calling them a sequester.

So maybe it's the rat moving through a snake or something.

It's a delayed effect approach.

The sequester reduced the amount of money that Congress allows to be committed by the Department of Defense and by the other federal agencies.

So it really starts there.

The in-year effect of the sequester is a reduction in the department's ability to obligate fundamentally.

That reduction takes some time to translate into revenue impacts, as the department actually has to turn a reduced level appropriations into specific contractual commitments.

And then those contractual commitments, once they are made, they play out over the life of the contracts as revenues.

So that creates this delayed effect in realizing the impact on revenues resulting from the sequester.

And if you kind of stand back and look at the different types of businesses in our Company and in our industry, the shorter cycle businesses will realize this effect the first, of course, because that delay effect is shorter.

And the longer cycle businesses will see it over a longer period of time.

And I think as you reflected in your question, awards is really the leading indicator of that effect.

And as I think I indicated in my remarks, we expect to see the impacts on revenue, earnings and, of course, cash flows trail that impact on awards over time.

And as I think Jim mentioned, when we were thinking about our guidance, obviously we are having to reflect the best knowledge that we have today.

That guidance does assume that the sequester does not result in cancellations or terminations of our significant programs but, clearly, there's still uncertainty regarding the ultimate impact of the sequester, particularly as we look out into next year.

And I think your question went to what should we be thinking about in terms of the effects on awards and book-to-bill.

I wish I knew.

We have yet to see that as we go through this year.

I think the real test will be what does the third and fourth quarter of this year look like?

So essentially the last quarter of this fiscal year and the first quarter of the new fiscal year.

That will inform us a lot and certainly will inform us on how 2014 will look and it is very likely that this is going to negatively impact sales in 2014.

I'll say it as clearly as I can in that regard, to think that the sequester somehow just dissipates and goes away and doesn't impact the future is putting your head in the sand.

So we expect there will be some continuing impact over time.

The magnitude of that impact in 2014 is hard to predict.

As I indicated, we've got a bunch of things in front of us.

We have to work our way through the actual implementation of the current sequester.

We have the debt ceiling issues in front of us over the course of the summer, which may or may not impact the outcome for the budgets for next year and how Congress deals with the President's budget that was put forward.

And we also have in front of us the overall strategy review that Secretary Hagel has launched, which is standing back to take kind of a broader look at the national strategy in light of the overall budget constraints.

So obviously it would be a little bit foolish to try and speculate on how that works out for 2014.

But in aggregate, given the impact of the sequester this year, I think it's fair to project that it will have a negative impact on 2014 revenues.

Okay.

Thank you very much.

Thanks, Jason.

Doug Harned with Sanford Bernstein.

Good morning.

Good morning, Doug.

I wanted to follow on that because when you look at your shorter cycle businesses, particularly on the Information Systems side, your backlogs did come down in Q1, and you've been very clear for some time that this is where you could see more of an effect.

And then if we head into sequestration, my assumption would be that there could be some impact in '13 and then more in '14.

When you take apart that business, where are you seeing most maybe downside in Q1 or the most risk going forward, either in terms of customer- civil, defense, intel, - or business type?

Can you characterize that a little bit?

Doug, this is Jim.

As I said in my comments, really the declines we saw this quarter -- quarter-over-quarter -- were across the broad portfolio of programs.

I don't know that I would characterize it as necessarily in one particular area or not.

And again, I think as we all know this is the shorter cycle business we have.

It's likely to be the first impacted, and it's probably also likely to be the first that starts to turn up when there is an upturn.

Yes.

I do think there are some effects in there that probably flow through before others.

We know -- I think everyone is aware -- that the O&M budgets are under the most immediate stress.

So the components of the IS business that connect to the O&M accounts see it first.

The Army budget is also a component of sales, and IS is, I think, probably even under more pressure from a longer perspective, not necessarily quarter-to-quarter but from a longer perspective.

So if I had to pick apart sort of the customer community drivers, I would say those are more immediate, but the reality is, as Jim said, all of our customers across-the-board are dealing with this.

There was not real flexibility provided to the department with the sequester.

So it's kind of as we thought it would be, should this happen, kind of across-the-board.

So intel, civil agencies, DOD -- all sort of the same dynamic?

Yes, they're all having to deal with this sequestered budget amounts, and they're all dealing with it in somewhat different ways.

But ultimately -- and I'm not just talking about the quarter, I'm talking about our view of the year -- we expect to see it manifest kind of across the board.

And, Doug, to be real clear here, we really haven't seen that large of impacts from sequestration at this point.

Largely, the declines that we saw were what we -- I would characterize as expected based on an overall budget decline environment.

Right.

Okay, thank you.

Thanks, Doug.

Joe Nadol with JP Morgan.

Wes, wanted to dig a little more, actually, into Information Systems and the backlog decline has been noted and your comments about that have been noted.

Just bigger picture though, this business is going -- what I would characterize and, maybe you disagree, in a direction -- un-Northrop-like direction.

You guys have been very clear about your pursuit of profitable business, and we see the margins in that segment.

But pricing is getting tougher and barriers to entry always have been low.

How are you thinking about navigating through this environment where really the business is going in a different direction from what you like to do with your businesses?

Yes, Joe, thanks for the question.

Our approach to that, and we've been at this now for a few years in IS, has been to step away from the components of that space that are going in the directions that you described.

And so part of what you've seen in terms of our top line in IS have been very focused decisions about where we're just not going to be in that part of the market.

And as I said, we've been at that for awhile.

I think you could see the benefit of that thinking in terms of our operating margin rate because we've been able to continue to generate good margins in the space by being much more selective in the parts of it where we compete.

So if I pull that thread a bit, IS has probably more hardware in it than I think most people realize.

If you look at the work that we do for the Department of Defense and the communications arena where, within IS, we're building the CNI avionics for the Joint Strike Fighters.

If you look at actually much of the work that we do for the Army that has hardware in content, those parts of the business certainly require a lot more engineering content.

They require intellectual property investment and create positions for us that are not just sort of commodity IT business framework that is often seen in the space characterized by IS.

If you look at the broader systems work that we do, that is generally characterized by also a lot of engineering content, whether we're building large command and control systems and missile defense is sort of a classic example of the work that we do in IS in that regard.

Those areas are classes of businesses that when you compare what's in our IS sector to other companies, other companies sometimes put that in something they would call electronics or missile defense or some other nomenclature for the title of their business.

So I am not as concerned about what we're seeing in the more commodity part of what I would sort of call the IT services businesses out there because that's a relatively small part of our business.

We do have some of that and we've made decisions to keep pieces of it where it connects to the higher value, longer investment perspective components of the business.

So I do wonder sometimes if we're doing ourselves a disservice by calling it information systems but, quite frankly, in terms of what it actually does, it provides information systems to our customer community and I don't want to re-label it and just put a different banner on it from a street perspective.

I want to make sure that our team understands their charter and what they are out there to do.

But the overall vector for that business I think is good over the longer period of time.

Clearly, as I said, it is a shorter cycle business -- most parts of it are.

And so we'll see some of those effects sooner, but when I think about this for the long term, I like what I see.

I like what we're doing, and I think it's going to continue to be an important part of our Company.

Thanks.

Robert Spingarn with Credit Suisse.

Wes, just on the back end of that question and then I have another one, could you characterize -- maybe give us a ratio in that business of what you'd call price sensitive to less price sensitive?

Let me ask Steve Movius to do that.

Steve, as most of you know, was formally the CFO of our IS business and I think has a good framework for describing that.

I'd be happy to.

Information systems - we really look at it in a couple of pieces.

One would be kind of services piece with a lot of what I would call high-end engineering content, contracts where we've been with the customer for often times very extended periods of time, quite a bit of that with restricted customers.

Most of our competition in that space are folks that are kind of the Tier 1 folks that you know pretty well.

On the systems side, that's about 60% of our business.

And again, there are, by and large, very few of the IT competitors in that space.

Again, most of the Tier 1 guys where you have to have significant capabilities to be able to compete effectively and where the customers value proposition is more on what you're delivering to them versus particularly a lower hourly rate, so to speak -- you might think about it in the services world.

So I hope that helps.

No, it certainly does.

And then just, Wes, if I go quickly in another direction.

One of your peer companies talked a bit about non-defense adjacencies in a recent earnings call.

Could you talk a little bit about where some of your opportunities are and then to any extent that you might be further contemplating portfolio shaping?

My perspective on adjacencies is that any healthy company should always be looking at its portfolio of capabilities in figuring out how to create value.

I think the experience of our industry suggests that the longer you have to stretch out your tape measure to measure how adjacent it is, the less likely it is that you're going to really create value.

So you have to be very thoughtful, both around the real practical application of the technology and a company's ability to understand and navigate the channels to market.

Turns out channels to market is every bit as important as the product that you think you have.

So our experience, generally, has been that there's more value to be gained by partnering effectively with other companies that simply have those channels to market and understand the economics and consumer, if you will, demands that are in those spaces.

So I would say there is a value creation opportunity out there for the broader use of technology.

You just have to be very thoughtful about how you pursue that and the degree to which you focus the resources of the Company in that direction versus sticking to your knitting.

But you wouldn't characterize it as a driver of your forward strategy?

No, I would not.

It's more an opportunity space that I would say that we look at.

And that comes and goes over time depending on where those technologies might actually connect.

If you turn back the clock to the latter part of the '90s, there was rapid growth in the telecom space that needed a class of technologies that derive from the defense industry.

So a number of companies, ours included, were able to navigate that and create some meaningful value during that time through some very thoughtful approaches to partnering with other companies to leverage that technology.

So it's a little bit dependent on what else is going on in the economy and where the needs are.

And that's really the, I would say, the way we think about it.

We're mindful of it.

We look at it, but it's not the primary motivator of our strategy, obviously.

We're a global security Company and we keep that in mind.

Thank you.

Sam Pearlstein with Wells Fargo.

Hi, good afternoon.

Hi, Sam, how are you?

Good.

I had a question which is, if I just look at your net favorable adjustments and I back those out, it still looks like margins were up 30 basis points from December and about 90 versus last year.

So I guess the first question is really what do you attribute that real change in performance to as to why the underlying earnings still seems to be better?

And then should we use this, call it $225 million of favorable adjustments, as the likely number for the future quarters this year?

Yes, Sam.

I hadn't done your math but, as I noted, earnings adjustments are down this quarter I would think to a more, if you will, normal level.

Last year, admittedly, had very favorable positive adjustments -we didn't think they would be able to be sustained at that level.

Ultimately, the margin rates for the four sectors in the Company are reflected in our overall guidance.

I feel comfortable with that.

Clearly, we're going to push the organization to do better.

Part of the improvement, as I noted, in margin rates is a result of the actions that we've taken over time that allowed us to harvest that benefit on our existing backlog of contracts.

And we'll realize that benefit over the life of that backlog set of contracts.

And a go-forward basis, we'll negotiate new contracts reflecting current cost at that point in time.

Thanks.

Thanks, Sam.

Bill Loomis with Stifel.

Hi, thank you.

Hi, Bill.

Thanks for giving the detail on the services.

Just kind of staying along that theme, you talked about the impact of sequestration earlier -- but I look at the guidance for the year for Technical Services and then IS.

So on Technical Services, if we look at the guidance for the full-year, it was down -- the actual was down 4% but it implies other quarters have to be down 13% to 14%.

Can you just talk about what the main drivers causing those lower year-over-year comparison?

And then on the other side with IS, given the full-year guidance, it looks like it's going to be relatively stable throughout the other remaining three quarters yet you talked about how sequestration would impact the shorter cycle side.

So is there things that are happening positively on the IS side to kind of offset that later in the year?

Thanks.

In terms of guidance, you might imagine in this environment we look at a whole number of -- a whole bunch of possible scenarios that have different sales levels for all the different organizations.

And as I do that, look at all those potentials, I come back to an answer that tells me that our overall guidance is supportive of what may -- what I would expect to happen for the year.

Yes, there's going to be some variation among the sectors as we go through the year and get a better clarification around whether or not there's going to be specific programs affected by sequestration.

The timing of when those occur will have an impact on this year's sales.

But, again, on an overall basis I feel good about the overall guidance.

I would point out that TS, for example, there are some programmatic effects that occur this year.

The ICBM program will be down on a year-over-year basis, just as part of a change in the program.

And that has been reflected in our thoughts about overall guidance at the beginning of the year for the TS environment as well as the total Company.

Bill, it's Wes.

Let me -- I'd just add to what Jim had to say on this -- just one other little piece to think about, and I think this is kind of a broader market perspective.

Our customers are clearly feeling the most intensity of the pressure in the near term around the O&M part of the budget.

And, obviously, the appropriations process tried to relieve a little bit of that.

But any of the businesses that are tightly connected to the O&M part of the budget, when we think through all the factors that Jim just described, that's a factor that really weighs into our thought process.

If you think about what's going on at DOD itself, they pay for their civilian workforce out of that O&M budget, and they are talking still about having to furlough some folks.

And when we're down to that level of furloughing and impacting readiness -- we've heard the Secretary of the Air Force talk about these awful effects of having to stand down training flights -- when we're having to make those kinds of decisions as a nation relative to the impacts of the sequester, it just really makes that part of the budget risk factor stand up for us and makes us even more sensitive to potential decisions our customers might have to make in light of the things that are weighing on them already.

So I just think it's important to keep in mind what our customers are having to work their way through in light of this somewhat ridiculous budget situation.

Okay, great.

Thank you.

Rob Stallard with Royal Bank of Canada.

Good afternoon.

Good afternoon, Rob.

Hi, Rob.

I'd like to follow on from what you just said about the state of play, so to speak.

The customers clearly got a lot of pressures at the moment.

I was wondering if you're all seeing that cascading down to you on maybe the price or terms of contract situation as obviously they could save some money, I guess, by the defense industry booking lower margins.

The way I would characterize that is things are taking longer to get done, and I think part of that is just a reflection of the turmoil that our customers are having to deal with.

And there's always a natural inclination to try and pushback on the margin rates and other aspects of the contracts.

Our approach to that has been, and I don't think we're alone in this, when you're looking at a total cost picture, the place to go to save the money is the 90%, not the 10%.

The 90% of costs, not the 10% of fee, or whatever the right percentages are on a particular contract.

So our approach has been to very aggressively go after cost -- cost from a cost structure standpoint and cost from a programmatic standpoint.

And I think in the places where we're able to demonstrate to our customer community that we are making progress in that regard, I think that helps this overall discussion immensely.

In the areas where the customers aren't satisfied with progress on that, then yes, there is a tougher discussion around what is the appropriate fee or incentive structure to help motivate improvements in overall cost.

And so, yes, I would say there's more intensity around that.

But to date, I think we've been in a position where we've been able to work with our customer community to get to outcomes that we view as fair.

Okay.

And maybe just a fine point on that.

Are you seeing the customer potentially trying to transfer more risk in the contract you sign up to as a way of perhaps saving some money going forward?

Each time we get into a discussion around an acquisition approach, the ultimate manifestation of that risk is contract type.

And there is, I would say, more intensity around what should be fixed price, what should be fixed price incentive versus cost plus?

And I would say we were seeing a little bit of a tilt, I think almost an overcorrection tilt, in the direction of fixed price or fixed price incentive for awhile.

If you look at the communication that Frank Kendall has been putting out, and I would say all of the service acquisition executives have been working on, I think there's a growing recognition that that might have gone a little bit too far, and there are really some things that the department really wants to be cost plus or perhaps FPI that were getting pushed towards FFP.

So I think there's a natural pendulum sort of cycle that we see in this.

And my sense is there's a little bit of a correction occurring right now.

But the pressures of the budget environment do cause individual program offices to have to rethink that and figuring out how they actually do their budgeting from a total cost, not just what they're putting on contract but also their margin or their risk assessment.

So it's a bigger -- I would say a bigger part of the dialogue, bigger part of the discussion.

But again, that's on us as well.

That's on the industry and our Company, in particular, to be very clear about what that risk balance is.

Great.

Thanks very much.

Cai von Rumohr with Cowen & Company.

Yes, thank you very much.

So a general question -- Secretary Hagel has sort of emphasized priority on cyber.

Your handout suggests that cyber is about a little under $2 billion out of IS' revenues.

Everyone defines cyber business differently.

Could you tell us when you talk of your cyber solutions, what do you have in that number and what are its prospects for growth and profitability this year and next?

Yes, Cai, it's Wes.

Let me say broadly I agree with you.

Everybody defines cyber somewhat differently.

It is one of these fields that's rapidly emerging.

And as we all begin to realize and, by the way I include our customer community, the tentacles of cyber and the necessity of connecting it so intimately to other components of the four structures, I don't think there's going to be an exact precise definition that everybody can look to and say, oh, that's an airplane and that's cyber.

Right?

I think it's going to be one of these things where we're going to have to build our way into a common understanding of it.

So as we have worked our definition of it, it has emerged over time from sort of the initial view that it was all about maybe defense and offense in the network domain to now include situational awareness more broadly in the network domain.

And then beyond that, it became clear that we needed to embed cyber capabilities into platforms and other systems that we're selling so there's an embedded component in it.

And then I would say even beyond that, there's a growing recognition of cyber as an integral component and perhaps the right words for basically the broader category of non-kinetic capabilities that is inclusive of things that may have historically been called electronic warfare.

So we are thoughtful in how we look at each piece and how we describe it, but I think what you're seeing from us is more of a reflection of the way that we would characterize the components of our portfolio that match to our customers emerging definition of cyber.

And as that definition continues to change, we're going to try and keep up with it, and actually help influence the perspectives on those tentacles of cyber.

So I apologize if that's not a precise definition for you, but it is a reflection of an evolving field and a field whose tentacles are increasingly intertwined in just about every other component of the defense architecture.

So given that to the second part of your question, growth, I mentioned in my comments that we were pleased to see the amount of funding that is evident in the President's budget for what I would say is the more traditional cyber -- the definition of defense, offense and situational awareness.

But there are components of the President's budget associated with the other parts of the defense infrastructure that are reflective of the need to imbed cyber in those as well.

So it's probably not going to help from a modeling perspective what I just said but I think from an understanding perspective it's important to recognize that this is going to be a moving target for awhile, which I think emphasizes its importance.

I think the question really was, how fast is it growing?

I mean it's a priority, but is it growing or is it relatively stable until some event in the future?

It's growing.

It's growing rapidly and trying to put a number on it would have to pin down the current state definition on any particular day.

But it's double digit growth.

Thank you very much.

Carter Copeland with Barclays.

Good quarter.

Thanks, Carter.

Just -- since we made it this far in the call and haven't talked about one of two topics that are so near and dear to your heart, Jim, capital deployment and pension -- I figured I'd at least knock one of them out.

(Laughter) Okay.

The guidance explicitly states that you're not considering a debt ceiling breach government shut down scenario.

But obviously that's a risk you've got to think about -- sort of tail risk you got to think about in your planning.

When you think about the -- your stance on capital deployment share repurchase as we get closer to that, should we expect to see some conservatism in how you manage the balance sheet and how you think about share repurchase?

Or is that -- are you in a position where you think you can continue the way you have in the past despite that risk?

Carter, I'd characterize our approach here as being mindful of all the risks that are inherent in our business, and then to plan for the possibilities that they all may occur at the same time, to be balanced, if you will, across cash deployment.

We don't guide on a quarterly basis, obviously, on share repurchases.

So we've talked about our plan for the year.

I really don't see a change in that plan at this point in time.

I think we're on pace to do that.

And at the same time, we're mindful of the potential risk around debt ceiling situation here in the summer and feel comfortable that we are able to deal with that as well.

Great, thanks.

Since it's Q1, I'll save the pension question for next quarter.

(Laughter) Thanks, Carter.

Myles Walton with Deutsche Bank.

Thanks.

Good afternoon.

Good quarter.

Wes, I'm going to go to the high level on sequestration one more time.

And the only thing I'm trying to get at is the last couple of years 4% organic decline has kind of been I think what you've showed -- 4% or 5% -- and this year pretty much the whole industry is at 5%.

And, Jim, I think you qualified that as being more reflective of a general defense spending declining environment.

So I'm just kind of curious, are you feeling better about the industry and your particular ability to manage sequestration?

Because it seems like they are giving you a lot of lead time to see it coming and is it just going to turn out to look like an extension of a down cycle?

Hard to tell yet.

The challenge here, obviously, that we're all struggling through in '13 is we've got to deal with the full-year sequester in half a year.

And so our customers are just really struggling to sort that out.

And I have to say, I admire them for how they're managing their way through this because it is so challenging.

And trying to predict where this goes on a '14 or '15 basis is difficult from a variety of perspectives that I mentioned before, trying to predict how the FY-14 budget process will work out, trying to predict the results of the strategy review.

Those are all sort of big challenges.

We are managing.

And I would say broadly across the industry we are managing because we are having to scale to go with what's happening.

And it's not what we would prefer to do, but it's what we know how to do, and we are going to do it.

And having some lead time on decision-making is always helpful so we can try and do this in a way that is most efficient.

But ultimately, as I've said very broadly and I don't want anyone to sort of hear that we're relaxed about this because we are not, the impact of the sequester will have long term impacts, even if it just gets turned off for '14 and beyond, the fact that we had it this year will have a ripple effect.

And if it goes on very long, I think just about anyone in our industry would tell you we are concerned about the impacts on our supply chain, and we're concerned about the impacts on our workforce, and we're concerned about how long it takes to turn the engines back on when the nation needs it.

And history shows the nation will need it.

So I don't want anyone to hear that this is just sort of business as usual, we'll figure it all out, and everything will be fine.

It's the wrong answer for our country.

But if you had to make the bet, would '14's decline be an accelerating decline versus '13?

I'm not going to speculate.

There's so many factors out there.

I think it would be foolish to speculate.

Okay.

Alright.

Thanks.

Thanks, Myles.

Sheverly, this is Steve.

I think we have time for one more question.

Your next question comes from the line of George Shapiro with Shapiro Research.

Yes, good afternoon.

Hi, George.

Two questions, actually.

Jim, I was wondering if you could quantify at all the potential cash flow impact from the Pentagon's switching from milestone payments to progress payments and also the effect of its slowing payments that had been accelerated last year for small business?

I'll take the second one first.

The move away from the so-called quick pay methodology that occurred in the first quarter impacted cash flows by, I would estimate, about $100 million -- negatively impacted cash flows by about $100 million.

In terms of movement from milestone payments to progress payments, George, you'd have to look at the broad portfolio of programs.

It is, as you know, just a timing question.

You do get paid, it's just how quickly do you get paid.

And so we continue to work these issues on a program-by-program basis, contract-by-contract, if you will.

Some progress, sometimes not so good but, again, I feel good about the overall guidance for cash for the year.

Then if I might -- one for you, Wes.

You talked about trying to focus on the 90% of the cost rather than a profit margin.

But as you've commented, in an uncertain environment that you're in where you don't have the same ability to see ahead like you might have had, how do you manage getting cost down in that environment so it doesn't wind up having an impact on the margins?

Fundamentally, our biggest lever has been our ability to manage our overhead structure in the Company.

And as I've said on earlier calls, we've been on a several year path to reduce headcount and reduce facilities as well as address other components of that cost structure, including pension, that we think have been necessary to help address that.

The next phase of it, obviously, is programmatic and every program in our Company is addressing that in some meaningful way.

And ultimately it depends on the nature of the individual program.

So we look at cost in a total composite.

We've had, I would say, more flexibility or opportunity in going after the overall cost structure or overhead cost components, but we are being very aggressive on it program-by-program.

George, if I may, if you really think about our business, we are a conglomeration of a bunch of programs or contracts.

Much of the costs on any of those contracts are people related cost and supply cost.

So the vast majority of our cost is essentially tied to our individual contracts or programs, and we can respond based on what happens to those contracts or programs.

So it takes a lot of disciplined management across the enterprise.

Okay, very good.

Thanks very much.

Thank you, George.

I want to thank all of you for your interest in our Company.

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

Thanks, Steve.

I'd just like to wrap up today by thanking our employees for all that they're doing to insure that we continue to support the men and women of our military services and our intelligence communities as they deal with this very challenging budget environment.

The sequester does have real negative impacts on these great people who serve our country and it's imperative that we all give them our support.

So thanks again for all of you on the call today for your continuing interest in our Company and thanks for joining us.

Ladies and Gentlemen this concludes today's conference call.

Thank you for your participation.

Goodbye.