諾斯洛普·格拉曼 (NOC) 2013 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Northrop Grumman second-quarter 2013 conference call.

My name is Carla and I will be your operator for today.

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

(Operator Instructions)

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

Mr. Movius, please proceed.

Thanks, Carla.

And welcome to Northrop Grumman's second-quarter 2013 conference call.

We have provided a PowerPoint presentation for the second quarter which you can access at www.northropgrumman.com.

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

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

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

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

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

Thanks, Steve.

Good afternoon everyone, and thank you for joining us.

We are very pleased with our second-quarter results.

They were achieved through the hard work and dedication of the entire Northrop Grumman team.

As a Company we continue to focus on performance and effective cash deployment as major value drivers.

In the second quarter these efforts drove a 9% increase in earnings per share and strong cash from operations and free cash flow.

This quarter's EPS growth reflects solid sales, higher segment operating income and lower weighted average shares outstanding.

Second quarter sales were slightly higher than last year at $6.3 billion.

Segment operating income increased 2% and segment operating margin rate increased 20 basis points to 12.7%.

Jim will provide more detail on the sales and margin rate trends, but the underlying drivers for this quarter's performance were higher sales and strong operating income and margin rates for our longer-cycle businesses, Aerospace Systems and Electronic Systems.

These positive trends were partially offset by budget-related top-line pressure in our shorter-cycle businesses, Information Systems and Technical Services.

Even considering that top-line pressure, as I look across our businesses, all in all, it was an outstanding operating performance from our team.

As a result of our strong first-half results, we are raising our sales guidance to approximately $24.3 billion and we are raising EPS guidance to a range of $7.60 to $7.80.

We continue to expect cash from operations of $2.1 billion to $2.4 billion and free cash flow of $1.7 billion to $2 billion.

Guidance for both of these cash metrics is before discretionary pension contributions.

We continue to be focused on deploying cash to create long-term value.

In May we raised the dividend 11%, our tenth consecutive annual dividend increase.

Our Board also authorized an additional $4 billion for share repurchases.

When we announced this new authorization, we indicated our goal of retiring approximately 25% of our then outstanding common stock, or about 60 million shares by the end of 2015, market conditions permitting.

During the second quarter we repurchased 6.1 million shares of stock for $489 million.

Year-to-date we have repurchased 12.6 million shares of our stock for approximately $900 million.

We anticipate share repurchases will reduce 2013 weighted average shares outstanding by approximately 7%.

At the end of the second quarter approximately $4.6 billion remain in our share repurchase authorizations.

In addition to share repurchases, during the quarter we also made a $500 million discretionary contribution to our pension plans.

We also raised $2.85 billion in new debt in the second quarter.

We used $850 million of these proceeds to retire debt due in 2014 and 2015 resulting in $2 billion of net new debt.

These transactions lowered our cost of borrowing, took advantage of historically low interest rates and allowed us to extend our weighted average debt maturity.

The additional cash from this financing activity enhances our financial flexibility in today's dynamic budget environment.

We ended the quarter with a total backlog of $37.7 billion, which reflects gross new awards of $5.5 billion an 87% book-to-bill.

Year-to-date gross new awards total $10.3 billion for a book-to-bill of 83%.

During the first half of the year, we received significant awards for programs such as F-35, Advanced EHF, Global Hawk, B-2 and the E-2D Advanced Hawkeye.

Generally speaking, the pace of new awards continues to be impacted by pervasive budget uncertainty.

Understandably, this environment is producing fewer new awards and reducing spending on existing programs, particularly in our shorter-cycle businesses.

While these businesses are experiencing more of an impact in the near term, we continue to see their longer-term value creation potential as integral to our Company's efforts in C4ISR, Cyber, and Logistics and Modernization.

Last month the DOD provided Congress with information on how fiscal year 2013 sequestration reductions would be distributed across spending accounts and funding lines.

At this point we do not see major disruptions to our 2013 revenues and the impacts that we are able to anticipate and quantify are reflected in our guidance.

Over the last several years we have been proactive in positioning the Company for a declining budget environment and we continue to aggressively examine all elements of our cost structure.

As I have said before, we believe that sequestration as currently enacted, will have serious negative consequences for our national security and will increasingly harm the defense industrial base over time.

While we won't be introducing 2014 guidance until next year, looking ahead we believe that reduced fiscal year 2013 budgets will result in lower 2013 awards.

And that the related impacts to Company revenues, earnings and cash flows likely will trail reduced awards.

The President's proposed fiscal year 2014 budget is $50 billion above the Budget Control Act Part 2 requirements.

Unless Congress acts to modify the Budget Control Act, we expect fiscal year 2014 sequestration will be triggered in January of 2014.

With so few Congressional working days left until the end of this fiscal year, a near-term agreement on 2014 appropriations seems unlikely, and we are currently planning for another continuing resolution and the potential for another round of sequestration.

While the budget environment is unpredictable and disruptive in the short term, we are positioning Northrop Grumman for the long term.

That means continuing to focus on aligning our portfolio with the enduring priority areas of investment for global security - Unmanned, C4ISR, Cyber, and Logistics and Modernization, along with manned military aircraft.

It also means achieving and sustaining a high level of financial and program performance and effectively deploying our substantial cash resources to create value.

Before I turn the call over to Jim, I would like to congratulate the Navy and the Northrop Grumman X-47B team on making naval aviation history.

Over the last few weeks the X-47B achieved several technical milestones.

These achievements culminated in the first-ever, fighter-sized unmanned aircraft demonstrating an arrested landing, when the X-47B landed on the USS George H W Bush on July 10.

The autonomous landing relied on computer-to-computer communications to establish the carrier's position and react to the dynamic variables associated with this type of landing.

Aircraft carrier landings are difficult and these technical milestones demonstrate that the Navy's goal of operating unmanned systems safely and effectively from aircraft carriers is well on its way to becoming a reality.

Together with the Navy, we also achieved another major unmanned milestone in May with the successful first flight of the MQ-4C Triton.

Triton is designed to allow the Navy to monitor significantly larger areas of the ocean with greater persistence than currently possible.

Triton's first flight represents a critical step forward in supporting the Navy's future maritime surveillance mission around the world.

Now I will 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 second-quarter and year-to-date results as well as our 2013 guidance.

As Wes said, this was another really good quarter.

Our team continues to focus on performance and execution, and I personally want to add my appreciation for our team's continued focus and dedication.

Turning to the sectors, Aerospace Systems sales increased more than $200 million, or 9%.

The single largest driver was the higher F-35 volume.

We've delivered 11 LRIP 5 units this quarter compared with no LRIP 5 deliveries in the second quarter of 2012.

You will recall that with LRIP 5, the F-35 program transitioned from cost-to-cost revenue recognition to units-of-delivery accounting.

We delivered the first LRIP 5 units in the third quarter of last year.

Unmanned revenue also continues to increase.

While our Global Hawk program is maturing, we continue to ramp up on other unmanned programs, such as NATO AGS and Fire Scout.

Space revenues also increased due to higher volumes for AEHF and the James Webb Space Telescope programs.

Those increases in Space were partially offset by lower volume for restricted space programs.

AS operating margin increased 15% due to the higher sales and a $26 million increase in net favorable adjustments, principally for Space Programs.

Based on year-to-date results, we now expect AS 2013 sales of approximately $9.9 billion, with a margin rate of approximately 12%.

Expected second-half revenues are modestly lower due to fewer F-35 deliveries in the third and fourth quarters of this year.

During the first half of the year, we delivered 21 F-35 units and 18 units are planned for the second half of the year.

Turning to Electronic Systems, sales rose 2%.

Higher revenue for International, Tactical Sensors and Space Programs more than offset lower volume in other product areas such as Navigation, Combat Avionics, Maritime Systems, Infrared Countermeasures and Laser Systems.

Operating margin on the other hand, increased 17% and operating margin rate increased 240 basis points to 18.2%.

The primary driver of the higher operating income is a $34 million increase in net favorable adjustments due to improved performance, principally in our Marine and Space Programs.

The remainder of the improvement reflects higher overall margin rates resulting in part from last year's favorable adjustments.

Based on year-to-date performance we now expect Electronic Systems sales to increase to at least $7.1 billion, with an operating margin rate in the low 16% range.

Revenue guidance includes a continued ramp up in International and Space volume and margin rate guidance anticipates a lower level of favorable adjustments than in the first half of the year.

Transitioning to Information Systems, second-quarter sales declined 9%.

The transfer of inter-Company efforts to our enterprise-shared services organization, as well as some modest portfolio shaping, accounted for $33 million of the decline.

Excluding the transfer and portfolio shaping, sales declined about 7%, with lower volume across a broad number of programs.

IS operating income declined as a result of the lower sales, a $27 million reduction in net favorable adjustments, commercial contract revenue timing and mixed results from the ramp down of several in-theater fixed-priced contracts.

Rather than looking at second-quarter's 8.3% operating margin rate, Information Systems year-to-date operating margin rate of 9.3% is more instructive as an indicator of ongoing performance.

As we mentioned last quarter, our guidance for IS had some modest downside risk to sales given sequestration and general budget impacts.

As a result of those trends, our guidance now contemplates sales of approximately $6.6 billion for Information Systems.

And we now expect a low to mid 9% operating margin rate, essentially consistent with the year-to-date margin rate.

Moving to Technical Systems, second-quarter sales declined 8% with operating margin declining 7%.

Lower ICBM and KC-10 volume impacted sales by about $40 million and portfolio shaping impacted sales by an additional $20 million.

The operating trend is consistent with sales and operating margin rate is roughly comparable to last year.

For 2013 we continue to expect sales of approximately $2.7 billion with a mid to high 8% operating margin rate.

So, on a consolidated basis, second-quarter segment operating margin rate improved 20 basis points to 12.7%, primarily due to the $25 million increase in net favorable adjustments in the quarter.

That improvement largely came from Aerospace Systems and Electronic Systems and then partially offset by lower net favorable adjustments in Information Systems and a smaller amount in Technical Services.

Total operating income increased 4% due to the higher segment operating income and lower corporate unallocated expenses.

Second-quarter interest expense increased $9 million, reflecting the one month of interest on the $2.85 billion of new debt at a weighted average coupon of 3.3%.

At the end of June, we used $850 million of those debt proceeds to retire the debt that was maturing in 2014 and 2015.

These actions, lowered our weighted-average borrowing cost by 11% from 5.3% to 4.7%, while increasing the weighted average life of our debt portfolio by 40%, from 9.8 years to 13.6 years.

For modeling purposes the net impact of these actions will increase our 2013 interest expense on a year-over-year basis by about $45 million, with most of that increase occurring in the second half of the year.

Turning to cash, before the $500 million discretionary pension contribution, year-to-date operations generated approximately $740 million to cash, generally consistent with prior-year results at the midpoint of the year.

Free cash flow on the other hand, before the discretionary pension contributions, totaled $692 million for the quarter.

And year-to-date free cash flow is $653 million, also consistent with last year.

At this point in time, we are maintaining our 2013 cash flow guidance.

As many of you know, our cash flows are traditionally weighted towards the second half of the year, heavily weighted I might add, with lots of variation around the timing of year-end cash receipts.

Given our lack of experience or knowledge regarding how the furloughing of government employees may impact the timing of payments in the second half of the year, we're maintaining our current cash flow guidance.

As we gain more experience regarding whether or not the furloughs will have any impact on the timing of payments, we will consider where we need to change our cash flow guidance for this year.

But in any case I expect this is only a matter of timing.

I also wanted to point out a couple of items that you will see in our 10-Q.

Total backlog at June 30 reflects the gross new awards of $10.3 billion and a $1 billion reduction in Information Systems total backlog, primarily to reduce unfunded backlog for expired periods of performance on active contracts, including task orders on IDIQ contracts.

Task orders are structured to provide the customer with significant contract flexibility.

As such, even when task orders are awarded and they become part of our backlog, there remains some degree of variability around execution of the entire task order amount.

We continually review our backlog of contracts to provide a reasonable depiction of the future work that they generate.

You'll also see in our 10-Q that we've reached a tentative settlement with the IRS for tax audit years 2007 through 2009.

If approved by the Joint Committee on Taxation, the settlement would reduce our income tax expense by up to $50 million.

As the approval and the timing are uncertain, the potential benefit of the settlement is not included in our 2013 guidance, which at this point assumes an effective tax rate of approximately 33%.

Finally, several of you have written reports regarding how the recent rise in interest rates could impact 2014 pension expense and funded status of our pension plans.

I think it is important that I provide some data on the potential impacts for our plans if the 2014 pension assumptions were to be set at the end of the second quarter.

As all of you know, that is not the case.

Actual assumptions will be set based on year-end interest rates and planned asset returns for the year.

If I were to use the 10-year treasury yield as a proxy, the discount rate would likely have increased by about 75 to 80 basis points from the end of last year.

While higher interest rates could improve our funded status to around 90% or so from the 83% level that we had at the end of last year, they also reduce returns on the fixed income and international portions of our investment portfolio.

As of June 30, plan asset investment returns were approximately 50 basis points.

Year-to-date returns largely reflect the impact of the higher interest rates on the fixed income and International portions of the investment portfolio, partially offset by strong market returns on the domestic equities portion of the portfolio.

To remind everyone, everyone, every hundred basis point difference in assets investment returns from our assumed 8% investment return for our long-term rate of return assumption changes, 2014 FAS expense by about $45 million.

Every 25 basis point change in the discount rate from our assumed rate of 4.12% at the end of last year changes 2014 FAS expense by about $85 million.

If I were to use the June 30 discount rate and asset returns as the basis for setting 2014 FAS expense at this point, 2014's FAS expense would likely be comparable to this year's FAS expense of about $380 million, or about $65 million higher than we anticipated at the beginning of 2013.

I should also point out that with those same assumptions, based on the June 30 numbers, our required cash contributions would remain under $100 million for 2014.

Lastly, I think again I should remind you that pension assumptions including those related to CAS are set at the end of the year based on actual year-end interest rates and asset returns.

And I know, as a number of you know, if we look back into the past a lot can change between now and then.

But I did want to provide you with some sensitivities for modeling purposes.

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

Thanks, Jim.

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

Please re-enter the queue if you have additional questions.

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

(Operator Instructions)

Doug Harned, Sanford Bernstein.

I am interested in Electronics, where you again had a very impressive margin.

It feels like after about six quarters in a row that upward adjustments because of good contract performance, it's become almost routine.

When you look forward and certainly with your guidance you're looking at lower margins for the rest of the year, where are you in Electronics in how you think about performance improvement, cost reduction?

I'm wondering what inning are we in, in terms of being able to continue to improve the performance of these programs and deliver the kinds of margins that we've seen over the last several quarters?

Doug, I don't know that I would say we are in an inning, we are on a treadmill.

You've got to continually run as fast as the treadmill is going.

We are really focused on that.

We have had, frankly, the benefit from the number of cost reduction actions we have taken on our backlog with, as well, a number of programs nearing completion, given the somewhat of a draw-down.

Really good, hard work by the Electronic Systems folks.

A lot of focus on being prudent about new contracts that we entered into, all of which are being realized at this point in time.

At times I get asked about our benchmarks for the businesses.

I do think that this is a 13%, 14%-plus type of business on a long-term basis.

But, we are realizing some benefits from hard actions that we have taken over the last couple years.

Yes, Doug, it's Wes.

I can't resist the opportunity just to say how much hard work is actually going on in Electronic Systems.

This is a team that has just completely focused on performance in all dimensions.

And if you turn the clock back a number of years, you will recall that we went through some pretty challenging times in Electronic Systems with, in particular, some international contracts that just simply did not perform very well.

And to their credit that team has top to bottom learned that set of lessons, really dug in on contract performance, really dug in on cost management, and they're doing an outstanding job.

As Jim points out, clearly we are getting the benefit of cost reductions, which flow into existing contracts.

As we enter into new contracts, that certainly is an effect we won't see forever.

But given your question I just can't help but reflect on the journey that we have been on in Electronic Systems, and really compliment the team for their extraordinary work.

And related, we are also seeing you deliver some very good Aerospace margins.

Are those more linked to specific programs such as F-35 maturing?

What is driving that?

I would say, Doug, it is across the broad portfolio of products in Aerospace.

I don't think F-35 is quite yet at a point of maturity where I would say that was a big driver for us.

I would agree.

But if you look across the portfolio in aerospace, to Jim's point, particularly our manned programs, more legacy manned programs and also our space program have been doing very, very well.

Unmanned is still earlier in evolution of things moving into production, so they're probably not quite as far up that curve.

But again, really good performance, really good focus on cost management.

Jason Gursky, Citi.

Jim, I wanted to ask you a couple of quick questions on cash.

You mentioned that there is some conservatism in your outlook here for 2013 in light of the furloughs.

Can you give us a little bit of flavor of how much conservatism you have baked into that?

What kind of cushion are you affording yourself?

Wes, you made a comment about the impacts of sequester out in 2014 with regard to revenues, profitability and cash flows, suggesting that they would be under some pressure.

But I did want to dive a little bit further into some of the moving things on cash, such as the discretionary contribution that you may or may not make next year, and then cash recovery rates going up.

I just wanted to make sure that your comments were excluding other dynamics that are going on with cash flows, and that we will not necessarily see negative pressure overall on cash flows as we move into 2014.

I do not think we will see negative pressures, Jason, on cash flows as we move into 2014.

I did not say conservative guidance.

Those were your words.

I was trying to emphasize that we always have substantial variation around cash receipts at the end of the year, in particular, frankly, as the industry manages cash flows.

Those last day cash receipts can easily vary by $200 million, $300 million just based on what is happening in the overall industry.

On one hand, yes, there can be some variation around the receipts, particularly in the last couple days of the year.

I do not know how to call what may or may not happen with the furloughing of government employees, and whether it has any impact at all on cash receipts.

It just seemed too premature at this point to bet on potentially higher cash receipts this year.

As I said in my prepared comments, I do think this is only a matter of timing, maybe only a matter of timing of days, but I think there could be some variability of cash receipts.

And it could be later this year simply because of the environment that we are in.

Jason, it's Wes.

I would add, I think what we are all worried about in different ways, is what the real impact will be of this furloughing of the civilian workforce.

It was just the other day that Secretary Hagel had to basically say, look, if this keeps going, we may be furloughing into the next fiscal year, as well.

And if anybody thinks that that has no impact, they are not thinking about it with a clear head.

The civilian workforce is an integral component of how our defense and national security infrastructure operates.

And it is not just paying the bills.

It is manning centers, running intelligence centers, it is you name it, our civilian workforce is extensively deployed throughout the national security framework.

I do think that there is some concern about what that means as we continue to experience this.

These are really important people doing really important jobs, and trying to predict exactly what the impact of these furloughs will be is a very difficult thing.

I think what you should take away from it is, sort of an expression of a risk factor, if you will that is out there in some respect.

But as Jim said, ultimately it is a matter of timing.

It's not a matter of do we get paid or not, it is a matter of timing.

Howard Rubel, Jefferies.

Wes and Jim, you're not afraid to do something that is unconventional.

Two questions, one is, why, with what you've defined as an uncertain environment, have you provided an element of certainty with respect to your share repurchase program?

Yes, Howard, let me say a few words about that and I'm sure Jim would be happy to join in as well.

We have tried to be as clear as we can over these last few years about the way that we see the value creation opportunity in our Company.

Clearly it all rests on performance and improving how we've been doing over the years in executing on our contracts and delivering on our commitments to our customers.

Everything starts there.

I am really proud of how our team has been working so hard over these last number of years to demonstrably improve our performance.

We're not perfect, we still have a lot of work to do, and we are pressing in every corner of the enterprise to go after that in terms of program execution and cost management, you name it.

It is across the board.

The other thing that we have been, I think, pretty clear about is the importance of the way in which we use our capital in creating value.

Obviously, it takes a number of forms, whether we are making long-term investments in our pension plan, which ultimately will be a lot of value over the long term.

Whether it's increasing our dividend, and as I said in my prepared remarks, we have taken a very long and steady approach to year-after-year consecutive dividend increases.

Or whether it has been about share repurchase.

The interesting thing about share repurchase is obviously, the market conditions permitting, we are in the market from quarter to quarter.

We often get the question of, gee, is this something that you guys are doing right now?

Or do you see it as a continuing part of your strategy?

As we thought about that question, and we took a hard look at our forecast on a go-forward basis, and as you might imagine we looked at it in a variety of scenarios, in terms of what might happen in the budget arena and programmatic decisions.

As we looked across that range of scenarios, we developed a great degree of, I wouldn't say comfort, you can never be comfortable in running a business.

But I would say we developed a great degree of confidence that the cash flows in our business supported taking the action that we took, which was to be clear about where we see ourselves going.

So that there wasn't this constant question about, what are we going to be doing?

We indicated what our goal is.

And we laid that out there and we are off executing on it.

We found it to be an important part of our continuing dialogue with our shareholders about the way we think about creating value.

And that really is the essence of our thinking.

Jim?

Obviously, Wes, I would echo exactly what you said.

The only thing I would add, remember, folks, that we announced our share repurchase and then about a week later we also announced that we were going to the capital markets for our debt transaction.

Having made those decisions, we thought it was important that we communicate both pieces of the decision so all the information was out there for the market in its entirety.

We are clearly focused on driving shareholder value.

See a significant opportunity there, but also tried to be very transparent with all of the market on what our intentions were.

I understand that and it makes -- it is just, you who have been so conservative to step out like this, clearly underscores your confidence or your, I guess your confidence in the outlook.

Related to that, I am sure this was not lost on you, Wes, is that Cisco yesterday bought Sourcefire for something like seven times revenues.

There is a whole host of your Cyber business and other things that clearly operate in some of those same markets.

How do you react to something like that?

Clearly, we watch very carefully what is going on in that whole market space, because as you point out Howard, we have some extraordinary capabilities in addressing elements of that market.

One difference obviously is, we continue to focus on the very high end of the cyber arena to help our nation address the big challenges that we are facing in that regard.

We have not put a huge energy into the commercial side of that, so there is some difference in market perspective and how different companies look at those things.

I would tell you that if I were standing in Cisco's shoes, I can understand what they are doing.

This was an important area.

I think it continues to grow and challenge in complexity.

As we talked about a little bit on our calls in the past, there are several different aspects of the flavors of cyber, if you will, ranging from the pure traditional perspectives on cyber to, increasingly, the view on what actually needs to get embedded in the hardware, if you will, the capabilities.

From our perspective that might be platforms or sensors, but it might also be networking equipment and other things.

I think it is just a representative example of how this issue has become more and more pervasive.

Growing in importance.

It is.

It's an absolutely critically important perspective on its growing importance.

I think we are going to continue to see it become a part of just about every aspect of the technology landscape that we all rely upon to make our world work the way it works today.

From my perspective this was just another indication of the importance of this arena.

Joseph Nadol, JPMorgan.

Wes or Jim, my comment, or my question, is on backlog.

Backlog is down, focus on funded, and I understand the issue in IS in the unfunded area.

Focusing on funded, you are down about 10% year to date in equal amounts in Q1 and Q2.

Some other companies' backlog has tended to be a little bit more seasonal than yours.

Yours does not seem to be as much so.

Obviously, market conditions are tough.

I was wondering if you can comment on where specifically you think you might end up the year on funded backlog?

And then, Wes, if you could, go through each of the businesses quickly, particularly AS and ES and comment on the major moving parts might be?

I would just, and I think addressed a little bit on our last quarterly call.

Trying to call it for the end of the year on backlog.

I wouldn't do it at this point.

There are so many variables out there that are shaping not only the decision space, but what I would call the behavior space, of our customer community.

Many of our customers are very, very concerned about decisions they make this year having to flow through into the next few years.

And they are holding back waiting to see what may or may not happen.

And I understand that behavior.

I understand that difficulty in making decisions when, in fact, they are getting asked to turn out a whole new idea on budgets every few weeks.

They are getting through an enormous number of what if cycles.

I actually admire how they are handling this in light of all the challenges that they are facing.

Where this all comes out and how that will translate into specific contracting behaviors over the course of this year, it is really hard to tell.

I wouldn't want to get in front of our headlights on that and try to call it.

What I would say is that it has put an emphasis within our Company on working with our customers to really help understand where things need to get put on contract to actually reduce costs.

Because as we all know, the longer things take often times that means there is additional cost induced by that delay in getting things on contract.

It is an intense source of effort across our enterprise to work with our customers to try and balance out the challenge that they are dealing with, as well as what it takes to maintain the cost of the systems and to make sure that things are operating as efficiently as they can in this environment, which is inherently inefficient.

I won't call it, at this point, on what the outlook will be for the end of the year just given the number of variables in front of us.

But I would emphasize that the degree to which it has the attention of the enterprise and working it.

You asked for AS and ES.

The vast majority of our revenues, certainly this year is like most other years, come from contracts already awarded.

It is not so much a big swinger on what our financial outcomes are this year.

And to the extent that we are aware of any, we've already included that in the guidance, the updated guidance that we provided today.

As we look across the landscape, there are a number of activities for a new contract, award activities, that are out there that will certainly impact the total, or could impact the total awards number for the year.

The challenge we continue to see in the awards environment, as you know, is you get an award, then it gets protested, and so you kind of hold back on that.

When I look at both AS and ES, they continue to have larger opportunities, competitive opportunities, in addition to the ongoing award cycles in front of them.

It is both domestic and international, where we see those opportunities.

One of the things that we pointed out, I think on our first call this year, was our outlook for 2013 has an increasing international content in our business.

International always takes longer than you hope it might, but we do see it on a positive aspect of the enterprise.

I hope that helps to some extent.

I know I didn't answer your question quantitatively, but I don't feel we are in a position to do that right now.

I do understand that.

If you characterize one part of this, which is the uncertainty that you have, the reason you do not want to answer the question yet, is it more the competitive items that are out there?

Or is it the timing of the follow-on items, whether they slip out of the year or not?

It is both.

Even the follow-on things are being slowed down just because the system is operating more slowly.

It is both aspects of that.

On the follow-on things obviously, in general it is usually not a matter of whether it is going to happen, it's usually a matter of when.

But as the customers are going through their internal debates on priorities, it is challenging for them to go on and get out there with those decisions.

William Loomis, Stifel Nicolaus.

Looking at Information Systems, so looking at the backlog write-down, tell me if I'm looking at this right, if I added back, the second quarter backlog it says that you had roughly a one-to-one book-to-bill in Information Systems in the second quarter.

Am I looking at that right?

I do not recall the numbers but I think it was around 90%.

Okay.

That is still a very good number given awards --

Gross awards, yes.

That is a good number, considering that award activity has been relatively light.

What's that say, what prompted you to write down the backlog?

And then you obviously had good awards in the second quarter.

We try to, on an ongoing basis, look at our backlog.

And as you might imagine, the most of variability is in the shorter-cycle business, particularly in those areas that have IDIQ contracts, which by their very nature provide some level of flexibility or variability on the actual amount of revenue that you recognize from each of those individual task orders, just to reiterate.

IDIQ means indefinite delivery, indefinite orders, so there's variability associated with it.

Yes, in this environment, we try to look at any kind of activity that may have a potential for an adjustment and we make those as soon as we know about them.

To be clear, you were just looking at awarded task orders and that is what you wrote down?

Correct.

Okay.

You had good awards in the second quarter, there.

What do you see in the second half?

Typically we see in the September quarter on the short-cycle side, a pretty robust period.

Is there anything that you have seen to date that you think differently about that?

I think we all have been speculating about what might happen here at the last quarter of the government fiscal year, but it would be simply that, speculation.

I think I will just leave it as we have that issue every year, will it be different this year?

It's really hard to say whether or not it will be any different.

Okay.

Separately, if you can review on Global Hawk specifically, the different variants, where we stand now, not in terms of where Congress is, but where you are in terms of production and revenue and visibility based on what is funded in hand now.

On Global Hawk, the remaining issue out there is the Lot 11 of Block 30 and we are in active discussions with the Air Force on that.

But you are still completing prior orders?

Yes, absolutely.

That will continue, you have visibility on that through '14, completing those orders?

There is a staging of what those orders look like, some this year, some over next year but there's really been no change in that.

Cai von Rumohr, Cowen and Company.

Thank you, and congratulations on a terrific quarter.

The one pattern I think we are seeing in the industry is that short-cycle businesses, the revenues are under more pressure, generally.

The margins are under more pressure and the weapons systems seem to be basically knocking it out of the park.

As those longer-cycle businesses come under more pressure, should we expect greater pressure on your margin?

So, to the question - do the margins just continue to get better and better beyond everyone's expectations, what is it going to take to continue that?

If we do see sequester impact on the top line, will that start to throttle those margins back or is that the key variable?

Well, Cai, as I think about this, the nature of our business is both some longer-cycle and shorter-cycle businesses.

In the longer-cycle businesses, as Wes alluded to earlier, we have the ability to work off of our backlog.

And to the extent that we don't have any unexpected surprises, no program cancellations or terminations, the nature of the contracting process normally provides you with some visibility on where the customer intends to go in the future.

My point simply is, in those types of the businesses, you have a longer period of time to react to what may occur.

We also made the comment -- have made the comment for a number of quarters now, that we have been conscious about trying to take cost reduction actions in advance of where we thought the market, our customer, was going.

And so, we have realized that benefit on our existing contract backlog.

As we negotiate new contracts, they will be negotiated based on our current cost structure.

And it will be harder to maintain the margins that we are realizing today out of the existing backlog.

That is the natural ebb and flow of the business.

Cai, I would also offer one other perspective, perhaps a little bit tangential, but I think it is important in a broader view.

The nation took a procurement holiday for strategic systems in the 1990s.

Over the last decade, we have been largely focused on dealing with the issues surrounding terrorism around the globe, and have really not still been able to recapitalize our platform infrastructure in any meaningful way.

We have an aging platform capability as a country, and we are going to have to replace that.

Things just don't last forever.

If there is any forcing function to continue a support for, I think the class of weapons capabilities that you were mentioning, I think that is actually an important strategic one.

Now, what will the sequester due to that?

What decisions might the department be forced to make?

Hard to tell.

That is a real force that is out there, right there today, and I think needs to be understood as a driving factor in the decision space here.

Essentially what you're referring to is whether or not we're going to have more production programs in the mix.

More productions programs than development programs.

Exactly right.

Carter Copeland, Barclays.

Wes, I wanted to ask, not really ask, but get your perspective on this EAC question and margin issue a different way, and apply it to capital deployment.

I wonder what the observation of the improvements you see in a performance over the last couple of years now tells you about what the performance must have been 3 to 5 years ago, which is the last time these stocks were at these levels.

When you think about the intrinsic value of these companies, we get several of both your stock, the stocks of your peers at levels that are now once again on all-time highs, how do you think about the intrinsic value of the firm, and that of your peers now that you have improved the performance?

Obviously, the profit policy hasn't changed, the budget is lower.

Does it make the case that intrinsically the companies were much poorer at their old prior highs?

And now they're much better, and it still makes a lot of sense to buy back stock here?

I'm interested in your perspective.

You have to look at it, I think, from a number of different angles.

Clearly the marketplace makes some decisions around EBITDA multiples.

If you look at that historically, I think that is illuminating.

I know a number of folks on the call have looked at EBITDA versus EBITDAP as better predictors over time.

If you look at that historically, you would say, well, we are probably actually in a reasonable place with the value opportunity that is still in front of us.

When we think about share repurchases, and I have said this a number of times on our calls, we think about it over the long term.

The long-term value of the enterprise, how we see ourselves generating cash, how we see ourselves with the ability to deploy that cash both internally to create longer-term value and directly to the benefit of our shareholders.

All of those things go into our thinking around the core economics of doing share repurchase.

Obviously, we have concluded it makes sense.

We have been pretty vocal about that.

And it actually stated a goal for where we would drive our share repurchase activities here over the next couple of years.

Everybody takes a little bit of a different view on this, but I think you can be informed by looking at it from a couple of different angles.

Fundamentally, it comes back to how you see the long-term performance and portfolio of the enterprise and how that aligns with the nation's needs and the needs of our allies.

That is really the core of our thinking.

Do think it is correct to say that it implies that the understanding of what performance was possible five years ago, let's say, is very different today than it was then?

I would hate to try and Monday morning quarterback what happened a number of years ago in the marketplace.

I know there were a lot of different factors in play then.

All I can do is snapshot my view of where we are and what I think our future looks like.

That is really the framework for decision-making.

Myles Walton, Deutsche Bank.

Good quarter.

Can we focus a bit on the specific of the F-35?

Obviously you moved into LRIP 5 here, it is adding nicely to the top line, presumably is not dilutive to the margin either.

So, I was hoping you could comment, five, six and seven, I think, are roughly the same quantities.

It would imply that you're not going to have much of a revenue growth rate, but that I'm curious of the margin potential over the next several LRIPs.

Is there a lot of margin potential, number one?

And the second piece of it is how much of those contracts are fully definitized at this point?

So Myles, let me say few words and then Jim certainly can add in.

You are right, the LRIPs are pretty flat in terms of the number of units being built, so I think over the next near-term period of time, we're going to see F-35 continue to be where it is.

We are still in LRIP land obviously, we're not into whole rate production and the multi-year productions, and so inherently the margin rates during development and even LRIP are not what the potential margin rates could be later on as we move forward into the program.

I hope we're going to be able to start up that curve in a more meaningful way.

We do have to get all the things done that are necessary at this stage of the program to be able to achieve that.

I think we are making really good progress on this program, and I would give credit to Lockheed Martin.

I think they're doing a great job as the prime on this.

I think we have a really good team with Lockheed and Northrop and BAE Systems and Pratt & Whitney, altogether on this.

We are working together on it in a very, I would say, highly aligned team-oriented way with our customer community.

I am of a mind that this program is making really good progress and I'm proud to be on this team.

I think it has got some really good future in front of it.

Now, how does it get interfered with potentially by all of this budget challenge that is in front of us?

I do not know.

That is a hard one to call.

The job we have in industry is to continue to drive to make it more affordable and to demonstrate the extraordinary capabilities of this aircraft, that alignment with what not only the US needs, but all of our partner nations need.

I see an increasing alignment around that on this program.

It, number one, really important, but as you point out these LRIPs are going to hold us flat for a while, until we can get up a more substantial production curve.

Over time I would hope to see the margins come with that.

Just to add, Myles, based on the planned quantities that we see ahead of us for all the LRIPs, we really don't see F-35 revenues ramping until about 2016.

As Wes just said, the team's, the entire team's focus is really on driving affordability.

How do we get unit cost down?

We all recognize that that is going to be an important factor in being able to realize the quantities that are ahead of us.

So, a lot of focus on how to drive affordability, reduce cost, improve performance, deliver on time.

And the margin potentially across the three LRIPs?

Is it roughly the same or is there pressure to the downside as you move out at flat quantities and customer wanting lower prices?

I wouldn't, I don't know that it's worthwhile commenting on margins by individual programs at this point in time.

We're really working hard to drive affordability.

This is about affordability.

Noah Poponak, Goldman Sachs.

I wanted to go back to the share repurchase conversation, a little bit more on the mechanics of that in the near and medium term.

When you announced it, you had said you could issue debt to buy back stock at a faster rate.

You've then added some debt not long after that.

Was that what you were referring to?

Or could we see more balance sheet capitalization changes?

Then, given you did that, should we look for a faster pace of buyback in the back half of the year?

Or should we specifically be looking for ASRs?

Anything you can give to help us there would be great.

We make all of those decisions essentially every quarter.

Looking at the pace of our share repurchase program, we did as you pointed out, go to the capital markets and raise some additional debt, a debt of $2 billion to increase our overall financial flexibility.

We could use some of that cash for accelerating share repurchases.

But essentially our message was around our goal to reduce our share count by about 60 million shares or 25% by the end of 2015.

Make it real simple, that is 11 quarters, kind of like 5.5 million shares per quarter on a pro rata basis.

We can do that on a pro rata basis, we can do it on an accelerated basis, we have the flexibility, the financial resources, to think about what makes the most sense in each time that we address a new program.

Could we do ASRs?

It is a possibility.

It's something that we look at on a regular basis to see whether or not we make -- whether it makes sense.

No commitment to any kind of formal transaction at this point in time.

And is it pro rata that is in the updated 2013 earnings guidance?

The guidance for 2013 was based on weighted-average share reduction of 7%.

We still expect to get a 7% reduction on a weighted-average basis.

It is going to be really hard, given that we are halfway through the year, to have a meaningful change in that average for the year.

I still feel really good about the overall 7% reduction for the year.

Our guidance anticipates that.

Carla, I think we have time for one more question.

Robert Spingarn, Credit Suisse.

I just wanted to go back to IS, follow on to Bill's question earlier, and the discussion about short cycle.

Wes, in the past you have characterized your IS business as being a little less commoditized, perhaps, than others.

But it seems like the pressure's still pretty strong there, particularly on the margins.

Jim, you did mention fewer EACs and a couple of other things.

Is this a trend that continues?

I know you have said the margins reverse a bit here in the second half.

We haven't bottomed here in the short-cycle pressure.

How should we think about this going forward and into next year?

Rob, let me make a little bit of a distinction, because I think sometimes this gets lost in the communication.

When we talk about commoditized, we talk about the way the market operates.

If there are many players and it is essentially a race to the nickel or to the penny contract by contract, that is commoditized.

That means that you're really having difficulty competing on the basis of technical differentiation or knowledge or intellectual property.

That is the framework we mean with commoditized.

Short cycle, some commoditized businesses, most commoditized business probably are short cycle.

Those two are not fully overlapping circles in the Venn diagram.

When we think about short-cycle businesses, we mean those businesses which inherently have shorter-term contracts.

Those may or may not be commoditized.

In fact, many of our short-cycle businesses are businesses that take extraordinary engineering skills to perform, rely on our ability to provide intellectual property and an experience base that simply is not commoditized.

Yet they are still short cycle, by nature of the way the customer buys.

I just would want to make that sure that those two do not get confused in the dialogue.

We have in fact moved away and have been doing this now for a number of years, from those businesses that we see as more commoditized.

We don't see that that is necessarily a place where make sense for us to invest a lot of our time and energy and resources.

We have focused in IS and more across the board, in those areas where the differentiation occurs on the basis of the intellectual capital that can be brought to whatever the particular competition might be, which inherently shrinks the field of competitors.

In fact, if you look at that smaller field that we tend to go after more on the systems side of this, I think you will see in the marketplace that has all of these earnings releases have been coming out, they we are all having the same experience.

Because of a lot of that type of capability is purchased on these IDIQ contracts, the customer has a lot of flexibility to throttle up or throttle down.

Given the budget uncertainties we are seeing more throttle down than throttle up in that space right now.

From a strategic perspective, we're on the track that we talked about.

We continue to focus our portfolio in the areas where we see our ability to be differentiated as creating longer-term value.

But we're going through a budget environment that is, for these shorter-cycle components of that, causing this type of variation.

Wes, are you saying that what we are seeing here in IS is not pricing-related?

This is about demand and volume and periods of softness.

Yes, I would characterize it as a market condition, not so much a competitiveness perspective.

Because the work that we have been doing in IS, I'm convinced, has us in a very competitive position.

It is more about what we are seeing in the market.

I think, Rob, a couple other perspectives on this.

In my prepared comments I talked about a $27 million adjustment or reduction in favorable adjustments.

I also mentioned commercial contract revenue timing, smaller impact, as well as the ramp-down of in-theater programs.

Frankly, a big part of that $27 million reduction in favorable adjustments is a result of some adjustments in last year's second quarter, resulting from immediate needs on production-type products in-theater.

I don't anticipate those would always be there.

Margins of almost 11% last year in IS in the second quarter, well above what we consider to be the benchmarks for this type of business, performance on a year-to-date basis in IS back basically in line with, again, what we see as the benchmark for this business.

Frankly, I think you're seeing an anomaly more in last year's favorable performance, than an unfavorable performance in this year.

But even so, you are talking about a lower margin in the second half then you were addressing in the first half.

Rob, we're basically saying consistent with the six-month's margin in the second half of the year with the first half.

Which is consistent with the benchmark that we see for this business.

Yes.

Okay.

By the way, Jim, on that, do you see EACs, could they continue to trend down?

Is this a business where maybe the maturity of the contract base suggests that is going to be a lower portion of your profit going forward?

Frankly, if we are again, still talking about IS, the IS being a short-cycle business, the amount of the adjustments that they traditionally have is relatively small.

This really is an anomaly.

Last quarter was an anomaly.

Last year, second quarter was much more.

While we're on the topic, the other businesses which are more long-cycle and have more EACs, Wes or Jim, are we at a point given that the new starts are fewer and further between and programs are closing out, how do see those trending, the EACs?

Our objective is to win every new start we can that makes sense, that is going to be profitable.

If we are successful in that regard, that inherently will hold the margin rates down a little bit.

Just in terms of our desires for our business, we like winning.

This concludes the Q&A session.

We ran over a little bit because we couldn't quite get to everybody.

I apologize for those that are still in the queue.

I will be in my office to answer additional questions.

At this point in time, I would like to turn the call over to Wes for final comments.

I will just say thank you again everyone for your continuing interest in our Company.

I'd also like to say thank you to the team here at Northrop Grumman for continuing to work so hard on performance and delivering value to our shareholders.

I'd also like to say thank you to our customer community.

They are dealing with an extraordinarily difficult set of challenges.

I really admire and respect how they are dealing with it.

It is not a situation that any of us should be putting them in, as they work so hard to defend our nation.

We ought to all keep that in mind as we go forward, and hopefully find some resolution to these challenges.

Thank you, everyone.

Ladies and gentlemen, this concludes today's conference call.

Thank you for your participation.

Have a great day.