諾斯洛普·格拉曼 (NOC) 2016 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Northrop Grumman first quarter 2016 conference call.

Today's call is being recorded.

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

(Operator Instructions)

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

Please proceed.

Thanks, Robin, and welcome to Northrop Grumman's first-quarter 2016 conference call.

In addition to filing our first quarter 10-Q this morning, we also filed a Form 8-K to recast the presentation of our consolidated financial statements for years 2013 through 2015, and the disclosures in certain portions of our 2015 10-K to reflect the changes in the Company's organizational structure and reportable segments.

We've also recast certain 2015 quarterly information as provided in Schedule 4 of today's Earnings Release.

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.

Matters discussed on today's call may also include non-GAAP financial measures that are reconciled in the Earnings Release.

On the call today is our Chairman, CEO and President, Wes Bush, and Ken Bedingfield, 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.

This was a good quarter and a strong start for the year.

So, I want to thank our employees for their unwavering focus on performance.

Our team continues to execute well and position the Company to achieve profitable growth over the long term.

In first quarter, under our realigned structure, all three businesses delivered strong results.

To remind everyone, we undertook this realignment to better focus our innovation and affordability efforts to provide our customers enhanced mission capability at a reduced cost.

By more effectively aligning and aggregating our product and services businesses, we enable greater operational synergy, and enhance our ability to develop, produce, sustain and upgrade our products over their entire life cycle.

Sales for the quarter were comparable to last year at $6 billion.

First-quarter segment operating margin rate was 11.8% and supports our outlook for the year.

Before the tax benefit first quarter earnings per share would have been $2.59, a 7.5% increase over last year's first quarter.

Including the tax benefit earnings per share totaled $3.03.

Cash from operations was a use of $60 million, substantially better than last year's first quarter.

Free cash flow was a use of $358 million and includes capital spending of $298 million.

The first priority of our capital deployment strategy continues to be investing in our businesses to position the Company for the future.

We continue to return cash to shareholders.

During the quarter we repurchased 1.5 million shares.

This quarter's share repurchase pace supports our guidance of a 6% reduction in weighted average diluted share count this year.

At the end of the first quarter, approximately $4 billion remained on our share repurchase authorization.

For the year, we continue to expect sales will range between $23.5 billion and $24 billion, with free cash flow of $1.5 billion to $1.8 billion, which reflects strong cash from operations and investments for the future.

As a result of the tax benefit and first-quarter performance, we are raising our 2016 EPS guidance to a range of $10.40 to $10.70 versus our prior guidance range of $9.90 to $10.20.

In addition to this quarter's solid financial results, I'd also like to highlight some operational achievements.

At Mission Systems, our SABR radar started flight testing for the US F-16 modernization program.

SABR brings fifth-generation radar capabilities to the F-16 by leveraging hardware and software commonality between our F-22 and F-35 AESA radars.

MS will begin delivering SABR for international F-16 customers later this year.

Also during the quarter, our BACN high-altitude airborne communications gateway achieved 100,000 combat flying hours, and continues to provide critical communications capabilities by translating and distributing imagery, video, voice and data to enhance communications and awareness on the ground and in the air.

At Aerospace Systems we successfully flew a SYERS-2 sensor on a Global Hawk, the first time this sensor has been demonstrated on a high-altitude unmanned aircraft.

Later this year, we expect to fly additional sensors on Global Hawk.

And we expect that Global Hawk will demonstrate its flexibility for supporting a wide variety of US Air Force operational requirements.

Triton, the maritime variant of Global Hawk, continued to make good progress in its operational assessments this quarter.

We look forward to a positive milestone C decision that would transition Triton to low-rate initial production later this year.

The highlight during the quarter was getting back to work on the B-21 program.

We're pleased that the GAO confirmed that the Air Force conducted an extremely thorough selection process and chose the most capable and affordable solution.

The next-generation bomber is critical to national security.

It will allow significant force projection anywhere in the world in an anti-access aerial denial environment.

We are absolutely committed to outstanding execution on this program and we are off to a strong start.

Northrop Grumman is a technology-driven Company.

Our team is pursuing innovation and breakthrough technologies to support the world's most technologically advanced military.

A successful partnership with our customers helps to insure military superiority.

This partnership requires innovation, affordability, investment and performance.

Investment on our part through IRAD and capital spending is critical, and performance on our part is equally important.

We are increasing investment through IRAD and capital expenditures as our opportunity set has grown, and we are committed to delivering very good returns on these investments.

Over the past several years we've demonstrated that as a Company, we can perform during a challenging down cycle.

That focus is even more important as we began work on important new development programs, and continue to position the Company for profitable growth over the long term.

To conclude, it was a good quarter and a solid start to 2016.

Our value proposition remains the same -- drive strong sustainable performance, generate cash, and effectively deploy that cash.

We continue to believe this is the right strategy and that it positions us for continued long-term sustainable value creation for our shareholders, our customers, and our employees.

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

Ken?

Thanks, Wes.

Good afternoon, everyone.

I want to add my thanks to our team on their continued outstanding work.

Today I'll briefly review first-quarter results and provide a little more detail on our 2016 guidance.

But before I do, let me provide some more detail on our realignment.

I'll start with Aerospace Systems.

The Azusa-based military and civil space business, formerly in heritage ES, is now part of AS.

And the electronic attack business, formerly in AS, is now part of Mission Systems.

AS continues to focus on manned aircraft, autonomous systems, and space business areas.

At Mission Systems, elements of our former Information Systems portfolio that were focused on sophisticated systems architecture and engineering, including both advanced software and hardware capabilities, are now combined with our former Electronic Systems portfolio.

This creates a more integrated business to support development of new capabilities for our military and intelligence customers around the globe.

Within Mission Systems we offer products and services in three major business areas -- sensors and processing, cyber and ISR, and advanced capabilities.

Sensors and processing is the largest of the three and is focused on land and airborne radar, EW, C2, and SIGINT efforts.

Cyber and ISR encompasses a combination of work from the two legacy sectors, including full-spectrum cyber systems and ISR collection, processing, and exploitation.

Advanced capabilities provides integration and inter-operability of net-enabled battle management, sensors, targeting and surveillance systems, air and missile defense, C2 and global battle space awareness.

Technology Services combines the service elements of our former Information Systems sector with the former Technical Services.

The new TS includes our health IT work and a majority of our civil work.

Technology Services' primary focus is on life cycle support and modernization of systems and platforms, as well as advanced training.

The business areas within TS are global logistics and modernization, advanced defense services, and system modernization and services.

Turning to our financial results, our first-quarter EPS included an $80 million or $0.44 per share tax benefit.

We early adopted an Accounting Standard update that requires recognition of excess tax benefits and deficiencies related to share-based payments as either income tax expense or benefit in the P&L, depending on whether the stock compensation awards best at, above, or below the grant price.

In addition, the update requires these items now be presented in operating cash flow rather than as a financing item.

Even before the benefit of the accounting update we had a solid quarter.

Turning to the sectors, Aerospace System sales rose 3% to approximately $2.6 billion due to higher volume for manned aircraft and autonomous systems.

In manned aircraft we continue to ramp up on the E-2D program, including production for Japan's first aircraft.

Higher F-35 sales also contributed as we delivered 13 units this quarter versus 9 in last year's first quarter.

Increases on these programs were partially offset by lower volume for the B-2 as well as fewer F/A-18 deliveries than in the prior period.

As expected, we delivered seven F/A-18s this quarter versus 9 in last year's first quarter.

Higher revenue in autonomous systems included higher volume for Global Hawk and Triton.

Global Hawk volume reflects the upgrade activity, as Wes mentioned earlier, as well as production activity on Korea's Global Hawk.

Triton volume continues to increase as we progress toward low-rate initial production.

Space sales were comparable to the prior-year period.

Aerospace Systems operating income declined compared to last year's first quarter and operating margin rate was 11.1%.

First-quarter operating income reflects lower margins on several manned aircraft programs, with a primary driver being the timing of risk reductions.

For 2016, we continue to expect Aerospace sales in the low $10 billion range with a mid to high 11% margin rate.

No change from prior guidance.

Mission Systems first-quarter sales were comparable to the prior year at approximately $2.7 billion.

Operating income increased 3% and operating margin rate expanded 40 basis points to 13.1%.

Sales reflect lower volume for cyber and ISR programs, partially offset by higher volume for sensors and processing and advanced capabilities programs.

For 2016 we continue to expect Mission Systems sales in the high $10 billion range with an operating margin rate in the mid to high 12% range.

No change from prior guidance.

Technology Services sales declined 4%, principally due to continued ramp down on the ICBM program, as well as lower volume for restricted programs.

Operating income declined in line with sales and operating margin rate was comparable to last year at 10.4%.

For 2016 we continue to expect sales in the mid $4 billion range with a margin rate of approximately 10%.

No change from prior guidance.

As Wes mentioned, our segment operating margin rate for the quarter was 11.8%, which is a good start towards our full-year guidance of high 11% for the year.

Total operating margin rate of 12.4% was strong.

And we continued to expect total operating margin rate of about 12% for the full year.

Our net FAS/CAS adjustment is unchanged at $275 million for the year.

And we continue to expect unallocated corporate expenses of about $200 million.

As a result of the $80 million tax benefit, our effective tax rate declined to 17.8% for the quarter.

And for the full year, we now expect an effective tax rate of approximately 27%.

Our updated 2016 earnings per share guidance of $10.40 to $10.70 reflects a $0.50 increase to the top and bottom of the range and continues to assume our weighted average diluted shares decline by approximately 6% to about 181 million shares.

We continue to expect 2016 free cash flow to range between $1.5 billion and $1.8 billion.

Our free cash flow guidance anticipates capital spending of $700 million to $1 billion in 2016.

First-quarter capital expenditures totaled $298 million and include $159 million for the purchase of a building previously leased by Mission Systems.

In addition to the building we purchased in the first quarter, we expect to close on another facility in the second quarter.

I'll conclude my remarks with a discussion of awards and backlog.

During the first quarter of 2016, the Company's total backlog increased, and reflects higher backlog at Aerospace Systems and Mission Systems and a modest decline in backlog at Technology Services.

The Company recorded various awards during the quarter including a portion of the B-21 long-range strike bomber program.

We intend to report backlog and awards on a full year basis for the Company and each sector in our 2016 Annual Report on Form 10-K.

We also intend to provide qualitative information on a quarterly basis, similar to this quarter's disclosure, until year end.

Before we begin Q&A I'd also remind everyone that beyond the statements in our prepared remarks we have no additional information to share on the B-21 award or the program in general.

I think we're ready for Q&A.

Steve?

Thanks, Ken.

As we open up call for Q&A, we ask each participant to limit themselves to a single question.

Robin?

(Operator Instructions)

Your first question comes from the line of Noah Poponak with Goldman Sachs.

Hi, good afternoon, everyone.

I wanted, Wes and Ken, to try to ask about margins going forward.

And I just heard the directive on one part so this is a multi-part that I'll try to wrap into one.

But we get a lot of questions from investors about, we've seen all of the new business wins and we think the top line can grow, but we hear concern that margins will go down because of all of that new business.

When I map it out, it seems pretty likely your F-35 business margins will improve.

When I map out your unmanned business it looks like margins could improve pretty significantly there because there's such a big mix shift to procurement from development and into international.

So, I think people get concerned that the bomber, being a new large development program, will be pretty dilutive to the margin.

But when I look at it, because bomber stays so much smaller than those other programs, total unmanned, F-35 and some others, for awhile, I actually arrive at the total Company having segment margin expansion pretty much every year for the next three to five years.

I know you probably don't want to give specific annual guidance but just directionally is that in the scenario analysis?

Am I missing anything with the margin trajectory.

Great question, and I wouldn't say that you're missing anything in terms of analysis of the fact that we've got a lot of moving parts.

We do have a well-diversified portfolio, and we've got some business that, you're right, should be driving towards some higher margins.

We have been realizing margins on F-35 that are below what we expect for a program at that level of maturity.

And we certainly expect as we move towards more mature production that we would realize higher margins in that area.

Autonomous Systems, we do see some international business that's moving into production, as well as Triton hopefully moving out of development and into LRIP.

So, we would expect to see the potential for some higher margins there.

Now, that being said, we do have a fair amount of development work that we're taking on, whether that's B-21 or some of the other strategic items that Wes mentioned, whether that's SABR or SEWIP or G/ATOR or others.

And in some respects, the question is what's going to move first and at what velocity among those various moving parts.

And I would say that overall, certainly some pressures on margin rates as development programs grow.

But, as you mentioned, we do have more mature production that's also going to be growing in terms of dollars.

The other one I probably should have mentioned is E-2 that's now into multi-year production.

So, we'll continue to work on it.

I see it as being range bound into a reasonable range.

We have the opportunity to continue to perform.

And we also need to work to try to offset the pressure that will come from the development margins.

Your next question comes from the line of Doug Harned from Bernstein.

Yes, thank you.

I'm interested in Mission Systems.

You made the comment that you're seeing this quarter lower sales for ISR and cyber, higher for sensors.

But if you look forward and you look at the pieces of that business, can you talk about where you see the growth trends?

Because that doesn't sound like it's representative of where this business is really headed over the next few years.

Could you comment on that?

Doug, it's Wes.

Let me just give you a sense of how I see things with respect to our Mission Systems business.

Our strategy in putting the parts of the legacy Electronics Systems and legacy Information Systems business together that we combined to create MS was precisely around, I think, what you're getting to, which is growth.

There's opportunity in that market space over the longer term, by integrating those capabilities together in innovative ways that I think will help position us quite nicely to do exactly what our customer needs us to do, which is to give them more capability at lower cost.

When I think about the core product lines in there, the areas that I see as having really good growth opportunities, clearly communications.

The work that we do in creating software-defined capabilities for communications is extensive, and we're continuing to see a great demand in that area.

Certainly combat avionics is a big part of the growth equation in MS.

Cyber, as we've talked about for some time, is another area that's growing well.

And I think you're all familiar with the fact that we have not only had a good IRCM business for some time, but last year with our capture of the CIRCM contract, that added to our portfolio of opportunity in that counter measures business.

All of those areas are, I think, examples of the types of businesses where we see really good growth prospects going forward for MS. Ken, was there anything you'd like to add on that?

I think you hit it on the head on that one, Wes.

I think that's the right answer to the question.

Your next question is from the line of Seth Seifman with JPMorgan.

Thanks very much and good morning.

I wanted to ask about the dividend.

Based on what you've done in the past, it would seem that you guys have an increase coming up potentially next month.

In part as a function of the rise in the share price, the yield is down to, I think, about 1.6%, 1.7%.

And how you think about where you want that to be going forward.

Seth, thanks for the question.

We do historically review our dividend for whether there will be an increase at the May meeting of the Board, so that is upcoming.

I would say that we've had a history of dividend increases for a number of years and we will consider that between now and that meeting.

I would just comment that in terms of chasing dividend yields we don't make a practice of chasing yield.

I would note that our yield is lower than some of our peers, primarily because of stock price performance as opposed to dividend historical increases.

We tend to think of dividend in terms of a payout ratio, and that payout ratio being pension-adjusted net earnings.

And we believe, if you look at our dividend in that light, you'll see that we're in a competitive range within our peer group, and that's the light in which we will continue to analyze this for the foreseeable future.

And your next question is from the line of Robert Stallard with Royal Bank of Canada.

Thanks so much.

Good morning, good afternoon.

A bomber question.

First of all, on the B-2 you noted that it was a bit lower in Q1.

Is this a trend or can we expect this program to remain steady going forward?

And, second, on the B-21 I know I'm not allowed to ask a question but I'll try.

Have you had any indication from the Air Force that they will be easing up on the classified structure of this program?

Thank you.

Rob, your first question on the B-2, I would say I do not believe the first-quarter volume indicates a trend.

This is one that has a number of aspects to the program and various pieces of business that run through there.

So, I think it's primarily just timing.

Modernization, more so, has a bit more fluctuation than the baseline maintenance and operations business.

As far as the B-21, I wouldn't be able to comment.

I think that's something we would leave for the Air Force to determine and comment on.

Your next question is from the line of Ron Epstein with Bank of America Merrill Lynch.

Yes, good morning, afternoon, guys.

It looks like in Mission Systems you guys said that the volume in margins were down for cyber and ISR.

It seems like in the past few years, both of those areas were growth drivers for the segment.

Is that decline a quarterly thing or are we seeing a shift in customer priority?

I think that it's important to be clear about what that was within that part of the business.

And I know it's a little bit difficult to track what's in the pieces quite yet, given that we're brand new in putting out a description of how we're categorizing the different elements of the business.

I would direct you to look at the 8-K that just got filed to help better understand that.

But the thing that was really driving that this quarter, the lower sales in the part of the business that we call cyber and ISR was actually a lower volume on the counter narcoterrorism technology program, CNTPO, which is an IDIQ type of contract with different task orders.

That's been fluctuating up and down over the years.

I would not describe that in any way as a core part of the way we characterize cyber or our ISR activities.

It happens to be a part of what got put into that portion of the business that we describe with that label.

So, we don't see any negative trends at all in the core cyber or ISR elements of our business.

But CNTPO with respect to some of the IDIQ task orders had some fluctuation that drove that outcome.

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

Yes, thank you so much.

Did I miss the backlog numbers?

Are we going to get restated backlog numbers for your three new businesses?

Cai, just to comment on the backlog, we are presenting backlog on a quarterly basis at this point on a qualitative level by sector.

So, we did provide information that AS backlog is up, MS backlog is up, and Technology Services is moderately down.

And I'd refer you to the 8-K for the details that are in there with respect to backlog.

Your next question is from Carter Copeland with Barclays.

Good afternoon, Wes and Ken.

Just a clarification and question.

I noticed there was no B-21 disclosure in the AS comments.

Is that due to the program's classification or because of its materiality, just to clarify that for us.

And then a higher level question for you, Wes, and it's about managing growth and performance simultaneously.

You've got a lot of programs ramping, you've got a lot of additional opportunities on the horizon.

But, clearly, executing on the cost performance on several of these programs, and none more so than the B-21, is huge.

So, I wondered if you might give us some insight into how you're thinking about how you manage that given the history of several of these programs and the importance to the customer of maintaining the cost targets that you've laid out there?

Carter, thanks for the question.

With respect to B-21 the disclosures are what they are.

You've got the material in what we have released that's what we're going to be able to disclose on it.

I really appreciate your question on growth and performance because it is a topic that we've been spending quite a bit of time on within our Company, and not just recently, having won a number of activities.

It's something that we've been working hard to be prepared for, for a long period of time.

The actions that we've taken over the last several years with respect to our focus on execution performance on our programs, I think is serving us very well in that regard.

I know a lot of folks looked at the margin expansion that we had over the last few years and thought -- that's just cost reduction.

Clearly cost discipline is an important part of it but, I will tell you, the big driver for all of those margin expansions was actually better performance, better program execution.

And that discipline in the Company has steadily been increasing and it is the focal point for just about every engagement we have with our leadership team in term of the actions that we need to be taking collectively to further enhance our ability to execute.

So, when we look at our new programs, the programs that we're taking on, we approach each of them from the perspective of how do we manage the inherent risk that goes with a new development activity.

And, first and foremost, that means being very clear about what all those risks really are, getting them out on the table as transparently as possible for all of us to focus on; and then, secondly, ensuring that we have very strong risk management capabilities and practices baked in for everything that we take on.

That's the discipline that we're driving in our execution.

In addition to our work in terms of being able to execute more effectively, I would say that there are some very positive trends in our customer community that are helping in this regard.

And one of the ones that I would point out is requirements stability.

There's a lot of work that's been done over the last few years as a result of the efforts, both at the OSD level and in each of the services, to enhance the acquisition team's ability to hold the requirements stable.

Because we all know, when it comes to these development programs, a major source of cost growth and schedule extension historically has been requirements instability, and we simply as a nation can't afford that anymore.

In order to execute well, we need to be able to keep the requirements stable.

We need to, of course, drive the execution with great discipline from the companies.

And I have to give the services and OSD a lot of credit for their attention to requirements stability.

I think that's going to help a lot.

Now, there's a third component to this that is also really important, and that is funding stability.

And given the volatility we've seen and the budgeting process over the last few years, this is an area where we need Congress to help, as well.

We need that stability to be able to execute well.

And when we get funding volatility on programs, that, too, can ripple the outcomes.

So, this is a matter of focus across the board.

It requires all the players, both the industry, the customer community, and the Congress to play their role in making these programs successful.

And we're certainly determined to do our part.

And I've been encouraged by what I've seen, both in the Pentagon and on the Hill with respect to the various defense committees recognizing the importance of all of these aspects to insure we can execute well.

But it's clearly right at the very top of the list of actions that we have within our Company to drive good solid execution.

Your next question comes from the line of Howard Rubel from Jefferies.

Thank you.

I'm going to ask the prosaic question, Wes, and go back to backlog again.

Sorry.

But it's very unusual for an aerospace company not to report a backlog number.

Could you go through the logic as to why you won't provide interim numbers?

Howard, it's Ken here.

At this point, I think the only comment I would make is to refer you to the 8-K, and just to remind you that we do intend to provide annual backlog data for the entire Company and at the sector levels in our 2016 Annual Report on Form 10-K.

Your next question is from the line of Jason Gursky with Citigroup.

Hi, good morning, guys, or good afternoon.

I wanted to do a quick clarification question, as well, and then larger one.

On the clarification, Wes, you mentioned the B-2 volumes look like they're a little lumpy this year, for some reason.

But can you give us a sense of what you expect them to be in 2016 relative to 2015, growth flat and shrinkage, and what the expectation is going forward.

And then the bigger question is, can you just talk about, again, for us all the pluses and minuses from a revenue perspective in the aerospace segment that we might see over the next several years.

We know about the F-18, we've got F-35.

Long-range strike will obviously see some growth.

But are there any other pluses and minuses that we should all be cognizant of as we go off to try to model the growth profile in that business?

Jason, I would say in terms of the B-2 volume question up front in terms of the lumpiness, I think that's just a quarter by quarter thing.

We do manage this business for the long term.

And no concerns about the B-2, where it is.

I would say overall we expect B-2 volume to be relatively consistent in 2016 with where it was in 2015, somewhere in the $700 million range in terms of sales volume.

In terms of the second part of the question on pluses and minuses and revenues at Aerospace, I would say, again, a fair number of moving parts.

In terms of what's declining, probably the biggest piece of decline would be F-18.

As that program ramps down I think we're down to a two per month delivery schedule.

The other areas where we've seen a bit of decline in 2016 versus last year would be non-restricted space, particularly AEHF and the James Webb Space Telescope.

In terms of adds to volume, we do expect that F-35 will start to ramp here at some point and we're looking forward to when that occurs.

The B-21 long-range strike bomber is certainly something that we would see as ramping here.

And then, as I mentioned, the E-2D program that is now into the multi-year production.

We talked about Triton moving into LRIP.

And then I would say a number of restricted activities.

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

Thanks, good afternoon.

Wes, I was intrigued to see the Company tie 30% of its annual incentive comp to pension-adjusted net income growth for the first time this year.

Your guidance would imply that it doesn't grow this year.

So, conceptually this year is one question.

But then also, I guess you're now comfortable that the Company, and maybe the industry, has entered a new back drop where it's not just a capital return but there's actually underlying year-on-year compounding pension-adjusted net income growth.

Myles, I appreciate the question.

It's a reflection of the way we think about motivating our team.

Clearly, if you look at the budgets that have been approved, 2016, in terms of the investment accounts domestically here were up about 14% over 2015.

And 2017, while not quite as robust in terms of the presence budget relative to 2016, is still up noticeably from where we had been in 2015.

Some question, obviously, about whether or not Congress can move beyond this two-year process of getting past the Budget Control Act or the sequester, and get us into a more stable long-term vector.

But if you do look at the present budget, it puts the investment accounts in a more robust position.

I think you might argue whether or not it's robust enough, given what's going on around the globe.

Given that, from a Company perspective, we see our portfolio as being very well positioned to take advantage of that healthier environment to better support our customers with products and services they really need to address that tough threat environment that's out there.

So, we are looking at that aspect of our incentive plan, even though it's stated on an annual basis, as something that we are integrating more into the thinking in the Company and the way that we're going to incentivize ourselves over time to make sure that we're translating this improved market opportunity space into actual increases in net income over a period of years.

So, we tend to use our annual incentive plan as a way of insuring alignment within the Company around the way we're thinking about what we need to get done.

You might recall a few years ago when we were taking on this initial thrust to change our outcomes on operating margin rates, we stepped that up incrementally over the course of several years.

But it was a very strong communication within the Company around -- this is our area of focus and this is the outcome we need to achieve.

And it was very effective.

I expect that as we go forward and focus on this transition in the market environment that we'll be able to generate a very positive outcome by insuring that our team is focused on growing the bottom line not just the top line.

We need to make sure we bring the bottom line with us as we're growing over time.

I would not describe this as an either/or on capital deployment or net income growth.

We do anticipate maintaining a very strong focus on returning cash to shareholders.

How we do that over the course of time always varies a little bit.

But, as I think you've heard both Ken and I say on our recent calls, share repurchase will continue to be a very important part of our strategy, as well as having a competitive dividend from a payout ratio perspective.

So, we look at all of these elements of value creation as being very important.

But I think you put your finger on it the right way in your question.

As we look at the changing market conditions it will be important for us to incentivize our team to make sure that we are growing bottom line as well as the top line.

Myles, if I can just add to that, I would say that I think Wes' point around the trajectory was important.

What we've done here is really set a baseline in 2016 where there's a trajectory for net income to grow from.

So, do not necessarily read this as 2016 net income as growing from 2015, but we've set a baseline that we're looking to grow from as we move forward.

Your next question is from David Strauss from UBS.

Good afternoon.

Another question on F-35.

Can you just update us where you are in terms of locking in the various contracts?

And then, Ken, a question around revenue recognition.

I think you're on units of delivery now.

The updated revenue recognition standard, how could that impact you on F-35?

And, if so, when?

Thanks.

Great.

Thanks, David, for the question.

I would say a couple things.

First, to answer your question on where we stand on contracts, just a reminder we do have four main contracts on F-35 with Lockheed Martin.

We've got the center fuselage, the radar, distributed aperture system, and the CNI communications navigation identification suite.

Various aspects of those are in negotiation with Lockheed Martin, but I would say that on what folks tend to think of as our main piece, that being the center fuselage, which is our single largest contract, we are negotiated through LRIP 8, continuing to work hard to get LRIPs 9 and 10 negotiated, just working through the details with those with our customer.

In terms of the question on the rev rec standard, a very good question.

We are on units of delivery for all four of our contracts on F-35.

And we also have other units-of-delivery contracts.

F/A-18 is one and some others within Mission Systems.

We do expect that when we adopt the new rev rec standard, which should be in the first quarter of 2018, we would transition from units of delivery on each of those contracts to a cost-to-cost method of revenue recognition.

That being said, we do not expect, in looking at the profile of those contracts that are on units of delivery, and where they are going to be in their life cycle, that the revenue recognized in that period should be significantly different from what would be recognized on the units of delivery basis.

The reason for that is that the cost throughput ultimately is pretty consistent with the unit flow that we see.

There could be some impact and there certainly will be some impact but we have not at this point seen that as particularly significant for the adoption of that new standard in 2018.

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

Good afternoon.

Ken, can you talk a little bit more about the capital spending?

You had the $150 million or so building that you purchased this first quarter.

It sounds like there's another one about to be teed up.

Can you just help me understand how to think about what that means for depreciation expense?

Does it mean CapEx is going to be near the high end versus the low end this year in terms of just now that you've actually executed some of those plans?

Let me see if I can address those in three pieces.

The first part is capital spending in the first quarter.

And what I would say is, yes, the building certainly was a significant piece of that.

The other piece of it, I think, is just continued projects that we've been working through in 2015.

And you can think of those as generally being related to either some of the centers of excellence work that we've been undertaking here in the last couple of years, as well as some that are programmatic in nature, in general supporting multiple programs, whether it's programs that are in production where we're seeing relatively solid production numbers in front of us, where we determine we can invest.

A great example of that would be the St.

Augustine Aircraft Integration Center where we invested ahead of the E-2D multi-year program because we saw that there was a relatively stable base of production for a relative long period of time.

So, I would say that some of it is the buildings that we've talked about, and some of it is continued spend on the existing projects, much of which is either centers of excellence or program related.

But, for the most part, if they're program they support multiple programs and not just a single.

In terms of depreciation, what I'd say is that we don't look at our indirect rates on a piece-by-piece or line-by-line basis.

We manage our indirects as a piece of our total cost.

And just because depreciation may be going up doesn't mean that we have an excuse to let our indirect rates increase.

So, we'll manage and we'll continue to manage this, as we have, as a component of total costs.

And to the extent depreciation is up, we'll have to find other areas where we'll realize cost savings.

I think a great example of that is just, if you look within the capital itself, the capital for the building we purchased in the first quarter and the capital for the building we intend to purchase in the second quarter will result in depreciation charges that are significantly less than the rent expense on those buildings.

So, there will be direct savings -- I shouldn't say direct, there will be savings in the indirect pools right there that would be a component of how we would offset those increases in depreciation charges going forward.

But we certainly see that as something we'll be able to manage, as we have in the past, aggressively looking at holding our indirect rates.

And then in terms of the range for CapEx, we certainly looked hard at that here as we were giving guidance for the first quarter.

We believe it's appropriate to hold our range where it is.

Still a number of moving parts and a fair amount of time between now and the end of the year.

But if we see additional clarity on that between now and the end of the second-quarter call we'll certainly update that range, as appropriate.

Your next question is from the line of Hunter Keay with Wolfe Research.

Hi, guys.

Thanks.

Good afternoon.

A question on IRAD.

How should we think about it?

Obviously it ticked up a little bit last year and I think I understand why that was the case.

But how should we think about that going forward, as a percent of sales.

And if you want to answer the question in the context of how DoD is maybe shifting a little bit of the development expense over to industry.

Are you seeing particular areas where that emphasis of industry spending its own money is particularly emphasized, like on radar programs or on unmanned, or anything like that, where you see a particular area of pressure to spend your own money to develop new systems?

Thank you.

Hunter, it's Wes.

I think the thing to keep in mind with IRAD, these are decisions that each company has to make on how it invests to position itself for the longer term.

That really is the framework that we look at when we think about IRAD.

We drive the process internally to really test, are we making smart investments that really have the opportunity, not just tomorrow or sometimes even just within a couple years, but over the long term, are these investments that are going to really generate the opportunity to enhance our ability to support our customer and to result in profitable growth for the enterprise.

There's a lot of judgment that goes into making those investments.

We look across the full array of customer needs.

And in response to the second part of your question, I would say all of our customers are looking at a threat environment that is going to require that they bring more innovation to the game, to the products they are out acquiring, they're going to need more innovation to insure that we are going to be able to put forth a military capability that truly is differentiated technologically.

So, it isn't just one area.

Probably all of the areas you mentioned plus many more are representative of our customers' needs today to really enhance their capability to address their very difficult and challenging missions, particularly as we look around the globe and see many other countries investing on the technology front, as well, in that regard.

This is a core part of what we do, our fundamental business model.

We invest, we bring brilliant scientists and engineers and mathematicians together to figure out how to help our customers stay ahead.

We don't want there ever to be a case where our service men and women have to go into a fair fight when it comes to the technology capabilities.

We want to be way ahead.

These are fundamental investment decisions that we make.

And given this growth in complexity that our customers are facing, I think it is incumbent on us, collectively across our industry, to be investing appropriately.

You saw us take our IRAD investments up over the last couple of years, up into the 3% range.

And I anticipate going forward we will be at that higher level of investment because we see the business imperative, both through our customers' eyes and through the eyes of generating returns on those investments.

So, long as we can make smart investments, apply those funds in the right direction and bring together the right human capital, we should be in a really good position to support our customers' needs.

So, that's the lens through which we see it.

I know that there has been a fair amount of public discourse about the need for both industry and, quite frankly, government to be spending more on investment.

But I think it's just a reflection of the reality of the threat environment.

So, we're stepping up.

We certainly need government to step up in terms of its investment in fundamental R&D and product development.

But I think this is something that's just a clear imperative and supports getting the right types of returns on those investments over time.

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

Good afternoon.

Hi, guys.

Wes, I was going to ask you a program question, and maybe it follows on a little bit from what you were just talking about.

You've always been viewed as a favorite for a UCLASS strike platform, which has now essentially been descoped down to a refueling system CBARS.

So, I'm asking about how that changes Northrop's competitive discriminators.

Does it alter where Northrop sees CBARS relative to other upcoming competitions, particularly given the major investments that you've made in the N-UCAS demonstrator prototypes?

Rob, that's a good question and I think a really important one.

As we look at the underlying capabilities that will be required to support essentially any meaningful unmanned operation off the deck of an aircraft carrier, we're absolutely delighted with the ground work that's been laid by the X-47B program.

Taking off from the deck of an aircraft carrier without a human in the loop is a neat trick unto itself.

But landing on the deck of an aircraft carrier is a really neat trick.

We're the only company that's done that.

It's something of a magnitude of capability.

So, we see ourselves as well-positioned to support whatever the mission requirement that the Navy derives for unmanned missions on and off the deck of aircraft carriers.

And we're going to continue to work hard to support the Navy on this.

Clearly, there are some differences that go with the variability of whatever the mission might be.

Strike, as I think about it from a long-term perspective is going to continue to be really important.

The Navy is concerned, as well, about surveillance and reconnaissance with a mission carrier asset.

And they've chosen to focus this next round of activity on refueling, which also is a really important mission for the Navy.

In all of those cases they are mission variant, but the underlying technology, the capability to design and build and reliably operate a truly autonomous system in that type of environment, that's something that we've made a lot of progress on.

X-47B was important for the Navy in terms of demonstrating that this really could be done.

And I think CBARS and future variants of that type of unmanned capability are going to be really important opportunities for Northrop Grumman.

And your final question comes from the line of Joe DeNardi with Stifel Nicolaus.

Thanks very much.

Ken, I'm wondering if you could talk about the pension side.

I think some of your peers are starting to see contributions ramp up over the next couple of years.

So, if you could just talk about what your required contributions look like going forward.

I would imagine it's a little bit smoother than your peers.

And then if you could just update us on FAS/CAS, maybe beyond 2016.

Yes, thanks for the question, Joe.

On pension, I would say that all things being equal in terms of where we are today versus where we were at the Q4 call in January, we provided some information on pension.

And without different assumptions, I don't see any changes from where we were then.

And at that point in time it was, I would say, about, call it, on average $100 million a year for 2016, 2017 and 2018 in terms of required contributions, primarily for our non-qualified plans.

And that was based on the discount rates at the end of the year and our expected rates of return.

I would say that at this point in time, no major update from where we are there.

We'll continue to evaluate that between now and the end of the year, and we'll tend to give some guidance around the third-quarter call and then update that with final assumptions at the end of the year.

We're looking at, again, with assumptions of today, not a significant level of pension funding requirements, which is certainly a good place to be.

Okay.

With that I'll turn the call over to Wes for final comments.

Thanks, Steve.

Let me just wrap up by thanking our team again for a good start to 2016.

It's clear to us that our customers really need performance and innovation to successfully address their demanding missions, and our team is absolutely focused on supporting them.

So, thanks, everyone for joining us on or call today and thanks also for your continuing interest in our Company.

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

Thank you for your participation.