諾斯洛普·格拉曼 (NOC) 2016 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Northrop Grumman second 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 our host Mr. Steve Movius, Treasurer and Vice President, Investor Relations. Mr. Movius, please proceed.

Thanks, Robin. And welcome to Northrop Grumman's second quarter 2016 conference call. 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. I would also note that after the conclusion of today's call we will be posting an updated Northrop Grumman overview to the investor relations page of our website. The overview includes detailed information on each of our three sectors.

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.

All right. Thanks, Steve. Good afternoon, everyone, and thanks for joining us. We had a very strong second quarter driven by solid operational execution and effective cash deployment. I want to thank our team for their unwavering focus on performance.

Second quarter sales totaled $6 billion, 2% higher than last year's second quarter, driven by growth at both Aerospace Systems and Mission Systems. At Aerospace Systems, we're reaching an inflection point where new programs and the planned ramp-ups on production programs are beginning to outpace declines on mature legacy programs. While we may see some variability in that trend going forward, the growth in manned and autonomous systems drove a 4% second quarter sales increase.

The programs driving sales include our restricted programs, the production ramp-up on F-35, Triton and volume on Global Hawk as we began production for international customers. These growing programs are more than offsetting the expected declines in AS program such as NATO AGS, F/A-18, advanced EHF and the James Webb Space Telescope. Sales at Mission Systems grew in the second quarter driven by higher volume for restricted programs and ramp-ups on programs like F-35, G/ATOR, SEWIP Block III, JCREW and CIRCM. We delivered our first CIRCM systems in June, and we expect this program to continue ramping up.

The reorganization at Technology Services at the beginning of this year has enabled us to sharpen our focus on reshaping this portfolio to better align with our strategy of providing differentiated services and capabilities in this market space. We see this as an important business for our Company. And while these portfolio actions may impact sales growth at TS in the near-term, we see this restructuring process as key to aligning our investments and capabilities at TS with our longer-term growth objectives for this business.

Enterprisewide, as we continue to add new programs and shape our portfolio, we remain focused on sustaining strong performance and operational excellence. This focus enabled all three of our businesses to contribute to a solid 12.2% segment operating margin rate in the second quarter and a 12% rate year-to-date.

Second quarter EPS increased 4% to $2.85 and based on our year-to-date results and a tax benefit that we will record in the third quarter, we are increasing 2016 EPS guidance to a range of $10.75 to $11 versus our prior guidance of $10.40 to $10.70. Second quarter cash from operations was approximately $600 million, consistent with last year's second quarter. Capital expenditures totaled $173 million and free cash flow totaled $431 million.

As we mentioned on previous calls our capital spending plans contemplate the purchase of several buildings this year. And during the first half of the year we implemented those plans with facilities purchases totaling approximately $240 million. This includes a facility purchased for $80 million in the second quarter. At the mid-point of the year, capital spending was $471 million, and we now expect our 2016 capital spending will range between $800 million and $1 billion. We continue to expect free cash flow of $1.5 billion to $1.8 billion.

In addition to investing in our businesses, we continue to return cash to shareholders. In May we increased our quarterly dividend 12.5% to an annual rate of $3.60, our 13th consecutive annual dividend increase, and our fifth consecutive double-digit increase.

We also continue to repurchase our shares. During the quarter we bought back 1.9 million shares, bringing year-to-date repurchases to 3.4 million shares. At the end of the second quarter, approximately $3.6 billion remained on our share repurchase authorization. We do not yet have an FY17 defense appropriations bill and as Congress has adjourned until September, it is increasingly likely that we will begin the government's FY17 with a continuing resolution.

As you know, a CR will constrain our customer's ability to achieve planned program ramp-ups and to start new programs. Beginning the new fiscal year with a CR has unfortunately become a familiar scenario. The larger concern is how long the CR lasts. Obviously the longer a CR lasts, the more disruptive it is to our customers' acquisition plans, so we encourage Congress to work together to fund our government and enable its effective operations.

In summary, we're pleased with our year-to-date results and we expect our focus on performance to continue to generate solid results for the remainder of 2016 as demonstrated by our updated guidance. We remain well-positioned to achieve profitable long-term growth and we continue to generate value through performance, managing our portfolio and our approach to cash deployment.

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

Thanks, Wes, and good afternoon, everyone. I want to add my congratulations to the team on our second quarter performance. Today I will briefly review second quarter results and provide a bit more detail on our 2016 guidance. It was a good quarter with higher sales and EPS and strong margin rates and cash flow. Performance was strong at all three sectors.

Aerospace Systems sales rose 4% in both the quarter and year-to-date periods. Increases in both periods reflect higher volume on manned aircraft programs and autonomous systems, which more than offset a low single-digit decline in space volume due to lower non-restricted activity on programs like AEHF and the James Webb Space Telescope. Restricted activities and higher F-35 deliveries were the growth drivers in manned aircraft.

Growth in these areas more than offset lower volume for the F/A-18 and B-2 programs. The F/A-18 continues to ramp down; we delivered five units this quarter versus eight units in last year's second quarter. Lower volume on the B-2 is due to timing of modernization activities.

In autonomous systems, volume continues to ramp up on Triton and Global Hawk, more than offsetting lower activity on other autonomous programs primarily NATO AGS. While space sales were lower, volume for restricted activities grew, but did not fully offset lower volumes for the non-restricted space programs I referenced earlier.

Aerospace Systems' operating income declined slightly. Changing contract mix and the timing of risk retirements more than offset the impact of higher sales. Operating margin rate was 12% versus 12.8% in the last year's second quarter. Most of you will recall that last year's results benefited from risk retirements on a restricted program.

At the mid-point of the year, Aerospace is on track to achieve our sales guidance in the low $10 billion range. Through six months, Aerospace has an operating margin rate of 11.6% and we continue to expect AS to generate a margin rate in the mid to high 11% range. No change from prior guidance.

Mission Systems second quarter sales grew more than 2% and year-to-date MS sales are up 1%. Both periods reflect higher sales volume for advanced capabilities programs, as well as sensors and processing programs. The primary drivers in advanced capabilities are restricted programs and ramp-up on several navigation and maritime programs including SEWIP Block III.

Ramp-up on G/ATOR contributed to higher sensors and processing volume in both periods and JCREW contributed to the second quarter increase. Mission Systems' second quarter operating income increased 1% and operating margin rate was 13%. Year-to-date MS operating income is up 2% with an operating margin rate of 13.1%. Based on year-to-date results, we continue to expect Mission Systems' sales in the high $10 billion range, unchanged from prior guidance. And based on strong year-to-date results, we are increasing our guidance for operating margin rate to the high 12% range versus our prior guidance of a mid-to-high 12%.

Technology Services second quarter sales declined 2% and year-to-date sales are down 3%. The trend for both periods reflects the completion of several programs in 2015, lower ICBM volume, as well as the ongoing repositioning of the business portfolio as mentioned by Wes.

Second quarter operating income increased 2% and operating margin rate expanded 50 basis points to 10.8% due to improved performance. Year-to-date TS operating margin rate has expanded 20 basis points to 10.6% and we are raising our margin guidance to low 10% from our prior guidance of approximately 10%. We continue to expect TS sales in the mid $4 billion range.

Total segment operating margin was 12.2% for the quarter and 12% year-to-date. We continue to expect a high 11% segment margin rate for the year. Total operating margin rate was 13.3% for the second quarter and 12.8% year-to-date. We now expect a low 12% total operating margin rate for the year versus our prior guidance of approximately 12%.

Our updated guidance assumes unallocated corporate expenses of $175 million, lower than our prior estimate of approximately $200 million. You will recall our unallocated corporate expense is typically more heavily weighted toward the second half of the year with the fourth quarter generally being the highest. We expect that to be the case again this year.

Our guidance also includes net FAS/CAS pension adjustment of $275 million. Keep in mind we will be finalizing our 2016 pension demographic study in the third quarter. The study results may impact our net FAS/CAS pension adjustment for 2016, so no change to the guidance until that is finalized.

Wes mentioned one of the drivers of our EPS guidance increase is the tax benefit we will record in the third quarter. After the close of the second quarter, we received approval from the Congressional joint committee on taxation for the resolution of the IRS examination of our 2007 to 2011 tax returns. As a result, our third-quarter 2016 income tax expense will be reduced by approximately $40 million. This will reduce our 2016 expected effective tax rate to approximately 25.5% and provide approximately $0.20 more in EPS.

All of that rolls up to our increased 2016 EPS guidance of $10.75 to $11, which continues to assume our weighted average diluted shares decline by approximately 6% to 181 million shares. We continue to expect 2016 free cash flow will range between $1.5 billion and $1.8 billion. Our free cash flow guidance now anticipates capital spending of $800 million to $1 billion in 2016 versus our prior guidance of $700 million to $1 billion.

A quick update on backlog. As we indicated last quarter, we intend to report backlog for the full year and provide trend information each quarter. Year-to-date, our backlog has increased and reflects higher backlog at Aerospace, a modest decline in backlog at Mission Systems and a high single-digit decline at Technology Services.

Looking ahead to next year and in light of the significant decline in interest rates through midyear, I thought it would be helpful to remind everyone of our discount rate and plan asset return sensitivities as they may impact our 2017 FAS expense. Every 25 basis point change in our discount rate results in a net impact of approximately $70 million to our 2017 FAS expense. And every 100 basis point difference between our 8% return assumption and actual plan return changes 2017 FAS by approximately $50 million.

In January we provided a $470 million estimate for 2017 FAS based on a 4.53% discount rate and plan asset returns of 8%. Year-to-date plan asset returns are a bit north of 6%, and as you are all aware, benchmark interest rates have declined by about 75 basis points. If we had to set our discount today, and holding all other assumptions constant, our expected 2017 FAS expense would be about $200 million higher or $670 million. But obviously a lot can happen between now and year-end.

We continue to expect CAS expense of approximately $1 billion for 2017,and we continue to expect 2017 and 2018 required cash contributions will remain fairly low at about $100 million each year. I don't expect much volatility in these required pension contributions barring major market disruptions.

One final note on Brexit. While it's too early to predict any long-term impacts Brexit may have on our business, we saw no material impact to second quarter results. We have limited foreign currency exposures related to the affected currencies and we hedge significant contract-related exposure. We did see a decrement in our reported cash balances in US dollars of about $30 million, which reflects the conversion of balances held in effective foreign currencies.

With that I think we are ready for Q&A. I'll turn it back over to Steve.

Thanks, Ken. As we open up the call for Q&A, we ask each participant to ask a single question and please rejoin the queue if you have a following question. Robin, if you could open up the line.

(Operator Instructions)

Myles Walton, Deutsche Bank.

Thanks; good afternoon, guys

Thank you, Myles. How are you?

I was hoping to talk a little bit about cash for a second. Lockheed brought up on their call the F-35 lack of contracts under signature being a headwind to ongoing funding of most of their suppliers and their work to make sure everything stays on schedule. Is there a similar kind of cash drag you are experiencing now? Can you size it and is it any risk to full-year cash flow?

Myles, thanks for the question. In terms of our cash on F-35 our profile is a little bit different than Lockheed's as they are prime and we are sub. We are on progress payments today as we perform on our work that's in the flow today and as we get on contract on LRIPs nine and 10 we will move to performance-based payments.

That will liquidate some of the withhold that we see. Primarily at the AS sector in terms of cash flow, but we fully expect we will get that resolved and should see that sort itself out by the end of the year.

Okay; thank you.

Richard Safran, Buckingham Research.

Wes, Ken, Steve, good afternoon.

Good afternoon.

Just a quick question here on Technology Services. Let's see if I got my math right. You saw 50 basis points higher margins on slightly lower sales. The only comment you made was improved performance so I wanted to ask if you could discuss the quarter in a bit more detail and maybe longer-term expectations. Near-term are you seeing a better mix of more favorable contracts? Thinking more longer-term, are business conditions improving overall? Are you seeing more favorable contract terms or is the margin improvement mostly just due to restructuring and taking out cost?

So I will start on that -- this is Wes -- and let me then turn to Ken to perhaps give a bit more color on some of the aspects. Overall when we say performance is the primary driver that is actually what we mean.

TS has a rather significant mix of different contracts across this portfolio. And credit to the team, they have been doing a really good job on executing on those contracts, so it's a broad reflection of the work that's being done across the organization just to continue to drive on program execution. Particularly I would say in the global logistics and modernization part of the portfolio where we are seeing some especially good program performance.

I mentioned in my earlier remarks that we are working on portfolio in TS. The reorganization that we did at the beginning of the year has allowed us to really pull together the broad set of our service and modernization-oriented activities and kind of step back and look at that market space and ask ourselves how we really want to position to compete over the long term. We're going through some thinking on which of those areas we're going to continue to invest in and others that we may tune down on as we go forward.

As I mentioned in my remarks, anytime we go through a little portfolio tuning, that can in the near-term impact the growth trajectory but over the long term we see this as a very good business for our Company. One that we're absolutely committed to being into. And the idea is to make sure we are investing in the places where we see really differentiated capabilities, and with differentiated capabilities we're able to focus on the areas that provide the better margin rates.

And that is our strategy sort of stated in a broad context, but we're looking at that, at the implications of that strategy, from each of the three parts of the TS business, so it's not just one of the components of that business that are the focus of this activity. And it's enabling us, I think, to better position the organization for longer-term growth. Ken, anything you would want to add to that?

Let me just add that I would say I agree it's a matter of TS having a broad portfolio of contracts that are generally differentiated in the types of services we offer. And just really good execution by the team this quarter. There was really no major program and no major areas that drove the majority of the increase.

TS is really -- all of the sectors are innovative teams that work really hard to deliver and they have shown they can do that this quarter. I would just say maybe another piece of it kind of broadly is disciplined bidding behavior and making sure we are going after the right work that can deliver the right margins as we look forward so I think that's an important piece of it as well.

Thanks very much.

George Shapiro, Shapiro Research.

Hello, George.

Good morning. Ken, your guidance for Aerospace Systems is low $10 billion range and the context of, Wes, your comment that this quarter is the first quarter you started seeing new programs outpace the legacy programs. So why wouldn't the subsequent quarters have higher sales, and why wouldn't the low $10 billion guidance be somewhat low for the year?

George, I would say that halfway through the year we are a bit shy of $5.2 billion in sales. We've got programs that are ramping in terms of volume and programs that are declining. We mentioned F-18, AEHF and James Webb on the declining side.

As we look at the profile, I think we don't generally see significant fluctuations quarter to quarter. We don't tend to see a big fourth quarter like some of the other participants in the industry and I think the other impact we are looking at is a fewer number of working days in the fourth quarter of 2016, which is driving a fewer number of second half versus first half days in the year based on our quarterly accounting conventions. So overall I would say that we see certainly a solid path to the low $10 billion range and the team will work hard to deliver solid results for the rest of the year.

And, George, this is Wes. I would just to add from quarter to quarter we may see a little bit of variability but I think the thrust of your question applied to the long term is exactly right. We see AS on an upward trajectory over the next number of years as we are executing that broad variety of programs that I mentioned in my remarks. While quarter to quarter we may see some little ups and downs, the trajectory that you mentioned is the right one.

Okay; thanks.

Thank you, George.

Sam Pearlstein, Wells Fargo.

Good afternoon.

Hi, Sam.

Hi. I was wondering if you could talk a little bit, philosophically I guess, about the cash balances. Just looking at you were down to $1.1 billion this quarter. It is as low as I can remember. I know the second half cash is always better than the first half, so that will build but just thinking about what is the right amount of cash to run the business? Does that make you think differently about how you return cash to shareholders and just trying to think about how we see things move from here?

Thanks for the question, Sam. I would comment that we are satisfied with the amount of cash we have on the balance sheet and satisfied with our liquidity position. It's a bit lower than where we were the second quarter of last year. I think we were a bit north of $1.25 billion, somewhere shy $1.3 billion last year at this time, so we're looking forward to a strong second half in terms of cash generation.

I think you will remember that's pretty consistent with our normal historical pattern of cash generation, although I am determined to figure out how to pull some of that forward into the first half of the year as we look forward. But overall, we don't have any concerns about where we ended up the second quarter on cash and look forward to a solid second half of the year and then delivering continued solid cash results from there as we move forward.

Sam, I would just add, it's always the balance. We want to put our cash to work and making sure we've got the right balance between putting it to work and having the adequate balance we need just to run the business is somewhat a reflection of the volatility that we see from time to time in the market space.

During the period of time where we were dealing with shutdowns and some of those other issues, that biased us a little bit more in the direction of a more significant balance. It's hard to tell that we're necessarily in a period of greater stability on funding, we will see how this whole CR process works out, but it's working to find the right balance in that overall equation with a strong bias towards putting our money to work.

Thank you.

Noah Poponak, Goldman Sachs.

Good afternoon.

Hello, Noah, how are you?

Pretty good. How are you, Ken?

Good.

Could you update us on the FASB change in the possible revenue recognition change where your units of delivery and I don't know if there could be a change or not on F-35 for you?

Sure. The rev rec standard, we do expect, will result in a change to a number of our programs, the F-35 probably being the largest in terms of those programs for which we are on units of delivery.

If you think about it, essentially we will take units of delivery sales in the year of adoption and we will take those years of delivery out and replace it with cost-to-cost sales, so generally we expect it to have a not too significant impact in terms of any particular year in regards to the P&L and the sales and earnings to be generated. Certainly something we're spending a fair amount of time on, our accounting folks are working hard on that.

We do expect to have that fully analyzed and our method of adoption identified by the end of 2016. I'd say we are well on track to dealing with that issue and we don't see it as significantly impactful to any particular P&L as we look forward.

Okay. It seems like potentially something like F-35 where the program is ramping pretty significantly and you are a long lead supplier, if you had to switch overnight to POC, it would sort of create a step-up in the revenue but it sounds like that's not necessarily the case.

The pull forward could result in a little bit more revenue than units of delivery. It really depends on timing in terms of what's being delivered that quarter versus the work in flow. It is still a little bit out in front of us. The closer we get to it, the more accurate I could give you an impact of what likely increase. There likely would be some increase there, although some other programs could result in some decreases going the other way. As we get closer, we'll be able to give you a better picture of that.

But you think you will be on it in 1Q 2017 basically?

1Q 2018.

Okay. So you'll just --

And a likely retrospectively look back.

Okay. Did you say you will decide exactly what you are doing by the end of this year?

By the end of the year, yes.

But you won't actually see it in the financial statements until 2018.

That's right. We will select our method of transition but the transition itself will be the first of 2018.

Got it.

Doug Harned, Bernstein.

Thank you; good afternoon.

Hi, Doug

I wanted to talk about Aerospace and you talked about expectations over the next few years for a ramp there. When you look across those next few years in terms of margin, you have really got the B-21 ramping up in development. I know it's something you probably can't say much about, but when you look at Aerospace as a whole, do you think you can maintain margins at current levels even with the mix shift? And I would imagine the people working there would like that too, given that incentives are tied to margin levels.

Thanks for the question, Doug. Let me start and maybe Wes will add some comments to the end. We've got -- in terms of mix, we do have some additional development coming in. We talked about the B-21 and there's always a mix of development versus production work.

The other piece of this is we've also got a fair amount of production. We spent a little bit of time talking about F-35 today as that production should mature and ramp. E-2D is mature production and Wes mentioned we're looking to get to LRIP on Triton.

We've got a bit working both ways. We do incentivize the team to perform better than the benchmark and its peers. You know that benchmark continues to be 11% for Aerospace. I would say maintaining historically a strong, level mix of production versus development. Will that move one way or the other?

Yes, I think development could move up, but I don't think it swings so wildly that margin rates are unsustainable. I think I have described margin rates as relatively range bound. We certainly don't expect any precipitous drop in rates and one thing we know is the team out there will continue to drive and find ways to perform.

I think Ken said it well, Doug. I guess the way I would frame it is if you look at the mix of development and production that we have, we have every opportunity to continue to do well on margin rate, so it comes down to performance. The other variable is how much more we win and we'd like to win some more.

We think we are well-positioned and we are working hard to provide our customers with some very innovative offerings so we would like to continue to add development content to the business as we can. But at the same time, and Ken mentioned this, we are going to keep the team incentivized based on our benchmarking process where we need to do better than the benchmarks. So we only want good wins. We want wins that will help us continue to perform well and where we are going to be able to deliver to the customer really good capabilities.

Our future wins could have a broad -- if you think about it in broad context, could have some impact on the mix. So again it's going to come back to performance. I think we have a good opportunity to continue to do well in the margin rates at AS while we continue to work on some additional captures to continue to grow that business. And bottom line is we've got to perform.

The mix as you see it now, it seems reasonable to you that you could keep margins here if you perform well, that there is no fundamental trend that's going to take them down, I guess?

I don't see a precipitous drop in the margin rates, assuming we continue to perform.

Okay; thank you.

Joseph DeNardi, Stifel Nicolaus.

Thank you very much. Wes, sorry for another question on Aerospace, but if you look at the three headwinds you've got this year, James Webb, AEHF and F/A-18, are those more of a headwind next year or does that start to ease a little bit in 2017?

Joe, I would say largely those headwinds start to ease a bit in 2017. The F/A-18 should flatten out and stay at a delivery level of about two a month. The others could see a little bit more decline as they continue to mature but I don't see it as a particularly significant drop in those programs.

Okay; thanks, Ken.

Jason Gursky, Citi.

Good afternoon, everyone.

Hi, Jason.

Wes, I was wondering if you could dive a little bit deeper on the TS restructuring. How long is this going to take? When do you think revenue streams could inflect higher there, get some growth out of it? What are you going to be prioritizing there as you work through this process?

So it's a little hard right now to project on the time line for it, just given the fact that as we make our decisions we, at the same time, make sure that we continue to support our customers. We are a Company that never leaves a customer high and dry simply because we have decided that we are changing a part of the portfolio.

Our approach -- I'll give you an example on that -- our approach on state and local where we have been pretty clear that we have been ramping down our business in the state and local marketplace over the last few years. And so we are not rebidding on a lot of new things, but in many cases those customers need us to hang in there a little bit longer to affect a smooth transition and we are committed to making sure we support them.

A lot of the variability here is on the nature of the customer needs to ensure nobody gets left hanging in some manner. We want to make sure we support them well. My experience on these transitions as we have gone through them over the last three years suggests that it takes usually at a minimum about a year but sometimes it can be a little bit longer than that to affect the portfolio shaping. Some of that gets assisted by where the new bids are. And we can elect, in many cases, to simply not rebid in an area that we are working to transition out.

And you asked for a few examples, so state and local is one where we are continuing to work our way down through that process. There are other areas, both in the global logistics and modernization programs, as well as our system modernization and services and our advanced defense services businesses, where we are looking at the nature of how the customer is buying. If there approach to buying is shaping things more in the direction of the commodity services, that is really not the part of the marketplace that we see ourselves as adding great value.

We tend to do a better job for our customers in areas where they need some aspect of technology componentry as a part of what they are doing or they need engineering applied to the outcomes for their products or services that they are looking at. That over time continues to shape and shift a little bit.

This is really down at the business unit level where we are sorting through each of these areas and making those decisions. And I think you will see the outcomes of some of those decisions as we begin to talk a little bit more about 2017 and then that will allow us to lock in on it, make sure we are investing in the right way and move through that as we move into 2018 and beyond.

Wes, let me just add to that a couple of other things to think about. One, for TS, I think it's important to think about its intercompany focus and the work that it does supporting and being really integrated with MS and AS and you've seen that growing as a percentage of TS's sales. And I would expect that's going to continue to be a strong and important part of its business.

One other impact as we look forward was a recompete this year where we bid what we believe was an appropriate margin rate for this type of work and unfortunately we were not successful in that bid, so that impacts the business as we look forward as well and all that's factored in.

Okay, great. Thanks, gentlemen.

Carter Copeland, Barclays.

Good afternoon, Wes and Ken.

Hi, Carter.

Just to follow up on that, Wes, when you look at TS, if you have someone else who doesn't have the same return hurdles or the same technology componentry focus that you do, is there a scenario where divesting of business as opposed to non-bids works? There's obviously a lot of movement in that marketplace, a lot of change of business models in that marketplace. Could that be part of the consideration as well? Any color you could provide.

We always look at that full range, Carter, of portfolio options, but I will tell you in this case what we see as the redeployment of people. We have a great asset in that business of just extraordinary people who can provide really good returns and provide really good outcomes for our customers as we better deploy them into these areas where we think there are better opportunities.

So my general bias in looking at a business like TS where we do have such an amazing group of employees is to just more effectively leverage that capability that we have into a place that makes a lot more sense for us to be. And, again, being mindful of and respectful of our customers' needs so we're not causing any customers any grief in the process.

So that's generally how I see this going. As always, and you've seen us do this over the last number of years, it's very, very clear that some part of our business would be better executed in the hands of another party, we're the first to step up and make that happen. But in general, just to give you my impression of how I see things headed at TS, I have a bias towards redeploying the amazing people that we have in that organization to ensure that we can be on the better trajectory.

Can you quantify how much redeployment that is as a percentage of the total?

Not really. And I think -- and I want to be careful that this doesn't come across as a huge sort of instantaneous transition of the business. We're just talking about the general factor that we see the business on. Again, I don't see a precipitous drop in any aspect of that business as we move into 2017, but when I compare the three businesses, AS and MS to TS, I would say we're looking for a more near-term reflection of our growth opportunities at AS and MS, and that will lag just a little bit in TS. That's the way I would frame it for you.

Great. Thanks, Wes.

Thank you, Carter.

Howard Rubel, Jefferies.

Thank you very much. I want to turn the discussion a little bit towards some of these new innovative programs that you are starting to capitalize on. I think there is two or maybe three. One is SEWIP; second is JCREW and, third, it seems to me that you have probably won some space situational programs. And could you address what you see both for that portfolio and how to build on it, Wes?

Yes. Thanks, Howard, I appreciate it. There is, as you point out, so much innovation that is occurring right now in attempting to insert some very new thinking into the way our customers are executing their missions. SEWIP Block III and JCREW are perfect examples of that and we're really proud of those wins.

I am especially proud of how the teams approached those areas. Those are reflections of so much of what we do in the Company that takes a number of years of investment in advance to really generate the level of technology capability that we can demonstrate to the customers and show them that they can achieve, in some of these cases, something that they didn't actually anticipate being able to do when they began thinking about the way they were going to formulate their mission capability.

And in all of these areas as we are able to not only advance the technology systems themselves, but better integrate these rapidly moving technology spaces, we are creating these types of outcomes for our customers and I am especially excited and proud about that.

SEWIP III, you mentioned, a really good example of how the Navy is thinking aggressively ahead on electronic warfare. And it needs to, given the complexity of the threat environment that the Navy is going to be facing as they move forward.

And in JCREW, if you look at what we have been able to do over the years in our communication space through the application of software-defined capability and the ability to integrate a lot of different ways of operating into singular devices, I think that's a really good example of that outcome.

You mentioned space and space is an area that I really think we're on the beginning next steps of a change in a way of looking at the space portfolio of the nation. For years we operated our space assets with sort of a perspective that we were in some sort of sanctuary in space and didn't really have to worry about a threat. And that has changed, it's changed dramatically over the last few years.

You've heard a number of senior officials and government talk about that shift in the thinking and that understanding. And consequently as we go forward, I think just about all of the space missions that are going to need to be recapitalized are going to be recapitalized with those concerns in mind, which inevitably moves the architecture of those missions in the direction of the application of higher-end technologies, which is what we do.

I think there will be quite a few very good opportunities for both our Company and the companies with whom we partner in addressing these new needs in space and we are investing to make sure we are in the right place on that and forming the right partnerships to ensure that we can together bring the capabilities our customers are going to need. So there's actually quite a bit of work that is going on in our Company and across our industry right now on the higher end of these technologies to ensure that our customers are going to be able to get what they need from us.

So if I interpret that, there are some study contracts that have moved forward and you are part of that?

There are, across the board on a lot of these things. Much of the advanced study work, as you might imagine, is classified so we are not able to talk very much about that, but I would just say there is quite a bit of effort and energy that our customers are putting into making sure that the application of these advanced technologies really does enable them to differentiate their war-fighting capabilities.

Thank you very much.

Thanks, Howard.

Cai von Ruhmor, Cowen and Company.

Yes; thank you very much. In your first quarter 10-Q, I think you identified $75 million difference between what you were assuming in recovery on equitable adjustment claims versus what your claim was. And I think you alluded to an REA in your current 10-Q. Could you give us the status of those first? Were both of those two REAs from the first quarter settled here in the second quarter? And was the one mentioned in the Q here that you settled in July, is that included in these numbers? And if so, what was the recovery? Thank you.

Cai, thanks for the question. On the REAs, let me cover it broadly. The one REA we discussed in the 10-Q was resolved in July. It was reflected in the numbers and does not result in a material impact for disclosure in the financials or the 10-Q.

In terms of the remaining REAs, there is a remaining balance that we believe is not material for disclosure. Working through that, or those, in due course and don't expect any material issues arising out of that certainly to the downside, and to the extent there's any material upside, we will include that in future 10-Qs or 10-Ks as the timing is right.

And then you mentioned also in the Q that you have, I guess, another potential $40 million or so tax pick-up. Could you basically explain what that's about and what has to be triggered to allow you to realize that?

There's a number of outstanding tax audits, Cai, that continue through the process. Some roll their way out and are realized, as we saw 2007 through 2011 was this quarter, and other audits, be they federal or state or other international jurisdictions, sometimes roll their way into what we call the early warning disclosure in terms of what changes we could see in the next 12 months.

It's just kind of a rolling inventory of a large number of claims and audits that our tax team works very hard to stay on top of and maximize our cash tax benefits. We're always making sure we are in strict compliance with tax laws and regulations.

Thank you very much.

Seth Seifman, JPMorgan.

Thanks very much and good afternoon. In Mission Systems, I think you noted in the 10-Q that the backlog was down slightly year to date. I think after the first quarter it had been up a bit. Wonder if you could talk about the order environment there and the possibility of ending out the year with that backlog higher?

Seth, I think one of the complications of backlog is it's really to analyze on a quarterly basis. We certainly being kind of the longer cycle businesses at AS and MS, we do see the impact of -- I wouldn't call it necessarily seasonal change in the backlog, but kind of fluctuations in terms of increases as large orders come in and decreases as you burn those down.

So I would say it's not unusual, pretty consistent with our historical timing of booking awards and our backlog balances and that's one of the reasons we don't guide on book-to-bill. In a long cycle business, it can be a bit lumpy and dependent on timing of getting awards in the door and when those contracts are signed and negotiated.

I understand. Thank you.

Hunter Keay, Wolfe Research.

Thank you.

Hi, Hunter.

How are you? CapEx at low end came up by about $100 million -- well, not about, it came up by $100 million, and you said the building purchase was $240 million versus I think the prior placeholder was like $300 million. So what's driving the increase there?

And as we think about the next couple years, two or three years out, are you finding there's maybe some unanticipated required investments with some of the ramping development work that maybe means CapEx stays a little more elevated than maybe some people are expecting or you were originally expecting, maybe closer to the $1 billion level going forward for the next few years? Thank you.

No problem, Hunter. I would say I don't think the profile of the CapEx for 2016 is surprising to us. We fully expected that we would have the facilities in the early half of the year and we have been executing on that, as Wes mentioned.

We have a couple of other major projects that are working their way through the system and we fully expected that some of that would be second-half loaded so we see a higher level of CapEx on the non-facilities side of things in the second half of the year. And we fully expect to be within the range of $800 million to $1 billion.

In terms of the future CapEx requirements, I think what we have talked about is we expect to stay elevated from our historical amounts, if you look back a number of years, for a few more years. And what we are seeing today, I don't see any significant change in our previous expectation as to where we are today on that outlook, so I think we would continue to say, not necessarily the number of facility actions in front of us as we saw the first half of this, but we do see as we grow the business and we are investing for the future profitable growth that we see in front of us, we will see an elevated level for a few more years, but no change from where we been in terms of the longer-term outlook.

Okay, thank you.

Robert Spingarn, Credit Suisse.

Good afternoon.

Hello, Robert.

If you will indulge me, I was going to try and tie two things together here into one question related to LRIP 9 and 10. The first component is the F-35 margin which, Ken, I think last quarter you mentioned was below where it might be relative to its level of maturity -- the program's level of mature at this stage.

And then the other part is the logistics side of the equation, which you both talked about a few questions ago. With this LRIP 9, 10 deal, are you getting -- I guess this is to you, Ken, are you getting where you want to get on margins? How should we think about this blueprint for affordability?

And separately the sustainment cost reduction initiative, what are the anatomy of these programs? Are they real initiatives that you cooperate with the customer or are they euphemisms for price deals?

Let me start on the margin side on 9, 10, and then I'll turn it over to Wes on the blueprint for sustainability. And I can comment briefly on blueprint for affordability, as I was a bit involved in that when I was in my previous role at the AS sector.

In terms of F-35 margin, I would say, yes, in fact, that the margin rates we are realizing on that program are not what we expect at this level of maturity. We're talking about LRIPs 9 and 10 moving into full-rate production and we would expect that the margin would be a bit higher than where it is today.

That being said, the negotiation of each lot is only the first step in that process and you've got to perform in order to realize the margin. We have been able to work hard with Lockheed Martin to get to an MOU on 9 and 10 for AS and we were previously there on the other sectors and now it's a matter of performing and delivering the margin that we expect out of that program.

From a BFA perspective, we did invest along with BAE and Lockheed Martin in the BFA through, I guess that was -- it was in 2012, 2013 time frame and I would say we have been making good progress on that working with the industry team and the government through that process. Any other questions on BFA, I'd refer you to Lockheed Martin for any other comment.

To comment broadly on the blueprint investments because just the tone of your question, I think perhaps conveyed a little bit of a negative view on them that I think is inaccurate. These investments, they are team investments that are focused on helping our customer get cost out, and as we do that, they have inherent in them a return mechanism for the Company so this is not sort of a sideswipe or some way of reducing our margin or something.

This is an overt decision by the industry team to come together to work on ways to actually get the cost, the unit costs in the case of the BFA's and the sustainment cost in terms of the BFS, to get the cost structure into a place where our customers can afford more of the capability. So from an industry perspective, we're only doing this because we see a benefit to the program and ultimately an economic benefit to those who are participants in the program.

And it's win-win because the government, our customers, get an economic benefit from these investments as well and have worked very closely with us in both structuring the investment strategies and programs and on ensuring that there is a good return mechanism. So we see them as very positive mechanisms, very supportive of the program objectives. And I think it has been a really good reflection on the partnership approach that we have together across the Companies on F-35 that we're able to make something innovative like this work so well. I'm very proud of these blueprint initiatives. I think they are a very good thing.

Wes, I think that makes sense. The part I'm curious about is I would think that you and Lockheed and BAE are working on these sorts of things in any event to get the cost down. And I'm just curious as to the role the customer plays here in catalyzing this?

So what's neat about the blueprint process -- and you're right, of course we're always working together to figure out ways of taking the cost down. It really does create a really good team environment with the customer because in some of these areas they have to make decisions to do things a little bit differently. It's a very good way of crystallizing a very effective joint process with not only the partners, but the customer to benefit the program. So I think it's a good idea and I'm glad to see us moving forward with AS.

And just on the logistics side, the sustainment side, just based on what was said earlier on other programs and we have this BFS, I guess it is, on F-35, are there different flavors here of sustainment programs? It sounds like some have become LPTA and maybe others aren't?

There is probably as much variability across sustainment programs as there is the number of sustainment programs. There are a lot of different models that are utilized by different customers, depending on how much work the government itself wants to do. How much they want to contract out the nature of the economic relationships they want to create.

It's a marketplace with a lot of different business models. And I think that's appropriate because we have many different types of systems at different stages of their life cycle with different levels of technology, different desires for modernization, so it's a very interesting and dynamic marketplace.

Robin, we're going to cut it off at this point in time, so I'm going to turn it over to Wes for final comments

Thanks, Steve. Let me just wrap up by thanking our team again for developing an approach over these last number of years that has allowed us to consistently deliver solid results. I think this quarter was another good demonstration of the team's focus and commitment on performance. But also the team is doing such a great job in positioning us so well for not only the remainder of this year but for the longer term, and for working closely with our customers to satisfy their needs as we go forward.

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

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.