諾斯洛普·格拉曼 (NOC) 2018 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Northrop Grumman's Third Quarter 2018 Conference Call.

Today's call is being recorded.

My name is Jamie, 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.

Mr. Movius, please proceed.

Thanks, Jamie, and welcome to Northrop Grumman's Third Quarter 2018 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 risks and uncertainties 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 our earnings release.

We have posted a slide deck to our IR website that summarizes our guidance, updates the 3 years of pension information we previously provided and includes a 5-year schedule of amortization of purchased intangibles and the step-up in depreciation of acquired property, plant and equipment.

On the call today are Wes Bush, our Chairman and CEO; Kathy Warden, our President and Chief Operating Officer; and Ken Bedingfield, our CFO.

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

Thanks, Steve.

Hello, everyone, and thanks for joining us.

I want to start the call by thanking our entire team for their continued focus on execution and performance.

Our third quarter results demonstrated robust performance with top line growth and strong operational execution.

The quarter include the first full quarter of results for Innovation Systems.

Based on our strong performance, we're increasing our guidance for the year.

Kathy and Ken will review the operational and financial results.

I'm delighted to note that for the first time in a decade, the Department of Defense begins its fiscal year without a continuing resolution.

The fiscal year 2019 defense appropriation bill received very strong bipartisan support, passing the Senate with a 93 to 7 vote.

We view this support, as well as the administration's focus on accelerating innovation efforts, as signals that the Congress and the Administration are aggressively addressing the threats emerging across multiple domains and are increasing our nation's pace of modernization and investment.

Our own programs continue to be well supported in the budget, and our portfolio is well-balanced between mature franchise production efforts and the development programs that will ultimately lead to the next generation of production programs.

In the context of an improving budget environment, we've aggressively invested in supporting our customers' need for advancing capabilities, including the addition of Innovation Systems, while also driving affordability.

We're focused on performing on our current programs and pursuing attractive new programs in our robust opportunity set.

Overall, I'm very pleased with our team's year-to-date accomplishments, and I'm excited about the many opportunities before us.

I'm also excited about the future of our company under Kathy's leadership.

She has demonstrated a solid focus on creating value for all of our stakeholders, and she brings the leadership capabilities and values to lead our great company forward.

So let me turn the call over to Kathy to give us an update on our third quarter results.

Kathy?

Thanks, Wes.

Good afternoon, everyone.

Wes, I want to first express our gratitude for the way you've led our team in creating value while always maintaining the highest standards of ethics and integrity.

On behalf of the entire Northrop Grumman team, we thank you.

My comments today will address third quarter financial and operational highlights for each of the sectors, including a status on our Innovation Systems integration.

Beginning with our financial results.

The businesses generated solid top line growth, and strong segment operating income and margin rates during the quarter.

Sales increased 23% to $8.1 billion, reflecting a full quarter of Innovation Systems as well as continued top line growth at Aerospace Systems and Mission Systems.

I'd also note that international sales rose 22% year-to-date, and we ended the quarter with total backlog of $52.6 billion.

We continue to see strong demand from international customers.

At the end of the third quarter, Japan announced their decision to purchase an additional nine E-2D Advanced Hawkeyes, bringing their total planned E-2D purchase to 13 aircraft.

Third quarter segment operating income increased 29%, and our segment operating margin rate increased 60 basis points to 12.1%.

In addition to this quarter's strong operating performance, third quarter financial results benefited from the settlement of cost claims, as well as a lower tax rate.

These factors combined to generate a 78% increase in third quarter net earnings and earnings per share.

As a result of our strong third quarter and year-to-date performance, we are increasing our guidance for 2018 earnings per share to a range of $18.75 to $19.

Turning to cash and capital deployment, our strategy remains the same: invest in the business, manage the balance sheet and return cash to shareholders through dividends and share repurchases.

During the quarter, after reflecting the discretionary pension contribution, cash from operations totaled $812 million and $1.45 billion year-to-date.

And free cash flow was $530 million for the quarter and $664 million year-to-date.

Based on those year-to-date results, we are increasing our guidance for free cash flow to a range of $2.5 billion to $2.7 billion.

So now let me touch on our sector highlights.

At Aerospace Systems, in Manned Aircraft we continue to ramp up on restricted activities and the F-35.

We're on track to deliver 116 F-35 center fuselages this year, which represents a 25% sales increase over 2017.

In Autonomous Systems, we announced the delivery of a Global Hawk autonomous aircraft carrying the Battlefield Airborne Communication Node, or BACN, to the U.S. Air Force.

We have received another contract to augment a BACN-equipped Global Hawk with the capability to link fifth-generation fighters with fourth-generation fighters and forces on the ground.

Global Hawk will be the first operational aircraft to provide this valuable capability.

And in space, the Northrop Grumman team was down selected to compete for the mission satellite payloads on the next-gen OPIR GEO missile warning system.

The competitive phase of the program will include development scope for critical design review.

This successor program to SBIRS, on which we were the payload incumbent, is an example of the Air Force's go-fast acquisition strategy to develop Advanced Capabilities.

The final down-select is expected at the end of 2020.

At Innovation Systems, shortly after the end of the quarter, we were awarded a $792 million launch services OTA for the development of the OmegA rocket for the Evolved Expendable Launch Vehicle program.

This agreement runs through 2024 and includes certification flights of OmegA's intermediate variant in 2021, and its heavy variant in 2024.

Three providers were selected in this phase to develop commercial launch solutions in order to have at least 2 domestic commercial launch service providers that meet national security requirements.

IS also supported two important launches during the quarter.

The Parker Solar Probe and the final Delta II launch deploying NASA's ICESat-2 satellite.

The Parker Solar Probe launch included the first-ever third-stage propulsion system for the Delta IV heavy rocket.

The ICESat-2 launch represented the 132nd and final Delta II mission for Innovation Systems.

Innovation Systems has successfully completed the first qualification test for its new rocket motor, the GEM 63, for the United Launch Alliance Atlas V after beginning the development just 3 years ago.

The successful completion of this test enables full production to begin with the first drop-in scheduled in next summer.

Regarding integration, we remain on track to meet or exceed our cost-reduction target, and we continue to be very excited about both the operational and revenue synergies we expect our combination to yield.

At Mission Systems, top line growth continues to be driven by Sensor and Processing programs.

During both the quarter and year-to-date, we had higher volume on restricted, electro-optical infrared self-protection programs, communications, the F-35 and the SABR radar.

We achieved several significant program milestones during the quarter.

In addition to F-16 SABR upgrades for multiple customers, MS successfully installed a production SABR radar on a Marine Corps F/A-18C, demonstrating our AESA radar's capability with that aircraft system and highlighting SABR's flexible and scalable architecture.

We are competing to upgrade approximately 100 aircraft for the Marines.

Also, during the quarter, we achieved important milestones on three development programs: CIRCM and G/ATOR in Sensors and Processing and IBCS in Advanced Capabilities.

Our work on all three programs demonstrates our ability to develop affordable, modular, open-system architectures that improve capabilities while also reducing total life cycle costs.

On the Army's Common Infrared Countermeasure system, or CIRCM, we achieved Milestone C after undergoing rigorous testing, signifying our system maturity and production readiness.

We are now moving to production on this critical life-saving technology for the Army's helicopter fleet.

We received the low-rate initial production order in the third quarter.

We also delivered the seventh G/ATOR ground-based radar system ahead of schedule to the Marine Corps.

We look forward to successfully executing G/ATOR's full rate production program, which is scheduled to begin in 2019.

In Advanced Capabilities, the Army awarded our missile defense team a $289 million contract to continue system design and development towards fielding the IBCS, which represents a paradigm shift for the Army's Integrated Air and Missile Defense.

We're working toward a flight test in late 2019.

And you'll recall that we also have a letter of agreement with Poland to acquire IBCS in conjunction with their Patriot purchases.

At Technology Services, our Global Logistics and Modernization work continues to grow as we ramp up on programs, like SEMA, and manage total life cycle solutions for Northrop Grumman platforms and those of other OEMs.

And we also captured the re-compete of the Army's mission command training program valued at $336 million over more than 4 years.

We've taken numerous steps to position TS for the future.

And as we look to ensure we are maximizing operational efficiency and continuing to posture for growth, we will be consolidating two of our TS business areas: Advanced Defense Services and System Modernization and Services into one unit beginning in 2019.

Our company is on a positive vector.

We are well positioned to our customers' needs, and we're demonstrating our ability to grow and create shareholder value.

We will be providing 2019 guidance on our fourth quarter earnings call in late January.

But looking ahead, we remain focused on achieving above-market long-term profitable growth with strong accompanying cash flows.

We're confident that our current portfolio of programs, our domestic and global opportunity set and the revenue synergy potential of Innovation Systems supports our positive outlook for 2019 and beyond.

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

Thanks, Kathy, and good afternoon, everyone.

I'll add my thanks to our team for their performance, and I'd also like to thank Wes for his outstanding leadership.

I'll briefly review our third quarter and year-to-date results and update our 2018 guidance.

Overall, it was a good quarter with solid awards and sales, with strong margin rates and earnings growth.

I'll cover the sector results and guidance for the remainder of the year then move to below-the-line corporate items, including pension.

Turning to sector results.

Aerospace Systems sales rose 5% in the quarter and are up 9% year-to-date.

Higher volume during both periods continues to be driven by higher Manned Aircraft volume, principally restricted activities and ramp-up on the F-35.

Autonomous Systems sales were also higher during both periods as we continue to ramp up on Triton production.

Volume for space was slightly lower for the quarter and year-to-date.

Aerospace operating income was up 9% for both the quarter and year-to-date.

Third quarter operating margin rate increased 50 basis points to 11.5%, primarily due to improved performance in Manned Aircraft and Autonomous Systems programs.

Year-to-date margin rate is 10.8% comparable to last year.

While AS margin rates continue to reflect the higher level of early phase development work, we're quite pleased with the year-to-date performance.

Based on year-to-date results, we're increasing AS sales guidance to a range of $13 billion to $13.2 billion, and we now expect AS will have a mid- to high 10% operating margin rate for the full year.

Moving to Innovation Systems.

Third quarter sales totaled $1.4 billion, which, when compared with the pro forma results for last year, represents a 16% increase.

Third quarter sales were higher across all three IS business areas.

Defense System sales reflect increased armament systems and missile products volume.

Higher sales for Flight Systems were primarily due to increased volume on propulsion systems and launch vehicles.

The increase of Space Systems reflects higher government satellite volume.

Operating income totaled $161 million or 11.4%.

Based on year-to-date results, we are increasing IS sales guidance to a range of $3.1 billion to $3.2 billion with a mid- to high 10% margin rate.

Moving to Mission Systems.

Sales rose 3% for the quarter and 2% year-to-date.

High single-digit growth in Sensors and Processing activities for both the quarter and year-to-date continues to be the primary growth driver for MS. Underlying mid-single-digit growth at MS is being partially offset by JRDC and ramp down on an ISR program.

Mission Systems operating income increased 11% in the third quarter and 2% year-to-date.

Third quarter operating margin rate increased 100 basis points to 13.7% and reflects improved performance across all 3 business areas.

Year-to-date operating margin rate of 12.9% is comparable to year-to-date 2017.

For 2018, we are refining our MS sales guidance to a range of $11.6 billion to $11.8 billion.

We continue to expect MS will have an operating margin rate of approximately 13%.

Turning to Technology Services.

Sales declined 12% in the quarter and 9% year-to-date.

Declines in both periods reflect our portfolio shaping as well as the program headwinds we've previously discussed.

JRDC, VITA and KC-10 essentially represent all of the sales decrease at TS for both the quarter and year-to-date.

I would also note that year-to-date, our Global Logistics and Modernization business continues to grow at a mid-single-digit rate due to ramp-ups on new programs like SEMA.

Technology Services operating margin rate was 10.7% for the quarter and 10.1% year-to-date.

Based on year-to-date results, we now expect Technology Services sales will range between $4.2 billion and $4.3 billion with an operating margin rate of approximately 10%.

As we roll all that up, we continue to expect 2018 sales of approximately $30 billion.

Based on strong year-to-date performance, we are increasing our guidance for segment operating margin rate to the mid-11% range.

On the corporate front, unallocated corporate expense declined by $112 million.

During the quarter, we settled cost claims and recognized a $223 million benefit.

This was a non-cash benefit in the quarter that will add to cash flows over a number of years.

This was partially offset by $97 million of merger-related items, including $89 million of amortization of purchased intangibles and $8 million of additional depreciation expense resulting from the step-up in acquired property, plant and equipment.

As you can see in our earnings release, we are presenting merger-related expense as a separate line item included in our unallocated corporate expenses.

We've also provided a slide that gives you a 5-year estimate of amortization of purchased intangibles and depreciation step-ups.

For 2018, we expect merger-related items to total $225 million, increase to $379 million in 2019 and decline annually thereafter.

Moving to pension, after completing our third quarter demographic study, we are increasing our 2018 estimated CAS pension cost to $1 billion, which results in a slight increase in our total net FAS/CAS pension adjustment.

Looking ahead to 2019, our net plan asset returns as of September 30 were approximately breakeven.

And based on interest rates on September 30, we would expect our 2019 discount rate to increase in the range of 50 to 60 basis points.

For your modeling purposes, we've updated our 3-year pension estimates, assuming breakeven net plan asset returns for 2018 and a 50 basis point increase in our 2019 discount rate.

The FAS sensitivities for plan asset returns and discount rate variances are consistent with prior assumptions and are also included in this quarter's slide deck.

Interest expense increased $60 million in the quarter and $196 million year-to-date, and we now expect net interest expense of $500 million.

Our 2018 effective tax rate should be in the mid-13% range.

Our third quarter tax rate reflects the reduction in the statutory rate, a $35 million benefit for our discretionary pension contribution and a $70 million benefit for additional research credits and manufacturing deductions for prior years.

As Kathy noted, we now expect 2018 EPS will range between $18.75 and $19, reflecting our improved operational outlook, the cost claim settlements; our lower effective tax rate and a weighted average diluted share count of approximately 175 million shares.

Regarding capital deployment, we redeemed $700 million of outstanding Orbital ATK debt on July 19.

In addition to paying down debt and contributing to our pension plans, year-to-date, we have returned $825 million to shareholders through dividends and share repurchases.

Through September 30, we've repurchased approximately 700,000 shares at an average price of about $307 per share.

Share repurchases remain an important component of our capital deployment strategy.

And at the end of our third quarter, our remaining share repurchase authorization was $2.1 billion.

We continue to expect healthy cash flow from the enterprise this year.

And based on year-to-date operational results, we now expect free cash flow to range between $2.5 billion and $2.7 billion after both capital spending of approximately $1.15 billion and our $250 million voluntary pension contribution.

With that, I think we're ready for Q&A.

Steve?

Thanks, Ken.

(Operator Instructions) Jamie, would you initiate the Q&A?

(Operator Instructions) Your first question comes from the line of Myles Walton with UBS.

I was wondering on Innovation Systems.

I mean, that's pretty stellar growth out of the gates.

And I'm just kind of curious.

I'm not one to usually believe in revenue synergy, but are you hitting revenue synergies in kind of year 1?

And what is the underlying growth rate you expect over the medium term for this business?

So Myles, thanks so much for recognizing the solid performance that our IS team delivered in this quarter.

We, too, are very pleased with what they've delivered.

I'll tell you, we are on track for the cost synergies that we defined for 2020, and we are making good progress on revenue and operational synergies.

Those are being worked.

Those will become much more material in the next few years.

A lot of the good performance that we're seeing right now is a result of just continued strong growth in the markets that IS serves.

We do anticipate that the revenue synergy, as I said, becomes evident in 2019 and much more material in 2020 and beyond.

Your next question comes from the line of Carter Copeland with Melius Research.

Congrats, Wes.

It's the end of an era.

Congrats on the performance.

It's been amazing.

Thank you.

I can't help but ask, given some of the other calls, I mean, you chose to no-bid two pieces of work that have now led to a bit of noise around bidding strategies and potential losses and whatnot.

And I just wondered if you'd share your perspective on whether you think this could potentially change bidding behavior, not necessarily for you, but around the industry.

And are we beginning to see differences in cost structures or product positioning with respect to KPPs or return hurdles?

Any perspective you could share on those, I'd appreciate it.

Yes, Carter.

I appreciate the question.

And I would just -- I'd offer two perspectives: one, through sort of the lens of industry; and the other through the lens of the customer.

On the industry side, clearly, every company has to make its own decisions about how it will approach the economics of any particular deal.

And they have to look at it both in terms of the deal itself and in terms of its broader base of business and how all those things factor together.

I like the process we've been using for a number of years.

We have a very clear-eyed view of what the economics are likely to be.

We've spent a lot of time thinking about true net present value.

And obviously, when you dig a big hole early, it's hard to get to good NPV.

But again, I would not presume to know the economics of other companies and be in a position to comment on how individual decisions get made.

And I would suggest that as we go forward, clearly, any company will have some finite appetite for how much of investment it can make in various areas.

And those appetites change a little bit from time to time.

But at the end of the day, we're generally a pretty well-managed industry.

When I look across the landscape, there are really smart folks running the companies in our industry.

And at the end of the day, they're going to have to make decisions that look at sort of their total picture, not just the individual project pictures.

And they're going to have to figure out how much appetite there is for different elements of those types of decisions.

On the customer side -- and the customer has to understand all of this as well.

We've gone through an era where this idea of low-priced, technically acceptable was kind of a mindset as we were navigating through an era where we are mostly concerned about the capacity of our force structure to deal with all of the different things we've been dealing with around the globe.

For those of you that have taken a careful look at the national defense strategy that we're operating under now, which I think it's high time that we have framework for our national defense strategy, there is a recognition that we've got to put as much and probably more focus on real capability, that our adversaries have taken full advantage of the focus that we've had elsewhere to not only catch up with us but in some areas, surpass us in some core capabilities.

And we've got to be investing in that direction.

When we're talking about capability and investing for capability, low-priced, technically acceptable is the wrong answer.

And from an acquisition standpoint, our customers, I think, are beginning to shift in their thinking and understand that they're going to need to use some different strategies when we're really talking about very high-end capabilities and the way programs are going to need to work to assure them that they're going to ultimately get what they need.

So the pendulum swings back and forth on these things over time.

I think it's important not to get too locked into one way of thinking about which way things are going to go.

But I do think that we are seeing a trend, as I said, more towards the high-end technology capabilities that are going to be needed.

And that will influence acquisition behaviors.

And hopefully, as we, the industry and the customer community, navigate that together, we'll stay on a track that enables the industry to be well managed.

Your next question is from the line of Jon Raviv with Citi.

Congratulations again to Wes.

Sort of following on that question, just some broader perspectives on investing in this growth environment.

If, for example, CapEx, it's -- been waiting for a few years for CapEx to peak.

Any visibility as to when that might come down again?

And sort of related is, as you make these investments, what's the sort of sales growth visibility associated with that?

Essentially, how long is the runway for sales growth now that we have the FY '19 budget in place?

Thanks, Jon.

Appreciate the question.

Maybe I'll lead off, hit the CapEx, and then turn it over to Kathy for a little more color on where she sees that as well as the sales growth opportunities.

In terms of CapEx, we have been investing to drive the growth that we are seeing in the existing program portfolio and the growth opportunities in front of us.

I would say that we continue to expect that CapEx will stay at an increased level in 2019, and then we should start to see it moderate as we look forward after that in both dollars and in a percentage of sales for sure as we continue to drive growth in the business.

I would say that there could be a blip beyond that if we're successful on some additional development programs.

We've been clear that GBSD is one that, should we be successful in the down-select from two to one, that, that is something that could drive some additional amount of capital.

But I don't think it's particularly material compared to what we've seen here in the last few years as we've been driving for growth, again, in the portfolio as well as some of the newer programs.

Kathy, did you want to add some color on that?

Just to follow on what Ken said.

We certainly see investing in ourselves as our primary focus, and we do have growth opportunities, both near and longer term.

We have been very pleased with what we saw in the '19 budget in support for our programs as well as the opportunities that we're pursuing.

And you will continue to see us have growth in restricted and pursue a significant set of opportunities, including GBSD that, if we are successful, could lead to additional CapEx expenditure.

But as Ken said, at the current moment, we see that starting to top out next year.

Your next question comes from Seth Seifman with JPMorgan.

I was wondering, this might be a bit of a sloppy calculation with the acquisition cost and stuff like that.

But on a pro forma basis, it seems like maybe you're about 3x net levered right now with close to $2 billion of cash to generate in the fourth quarter to take that down.

So how do you think about when you can really kind of get back into the market to buy back stock?

I would say, Seth, that as we look at our leverage, we are quite comfortable with where we are from a leverage perspective.

We're able to take advantage of our credit rating at the time of the acquisition to execute on the acquisition, the issuance of the debt and to essentially see a single-notch downgrade from a couple of the credit rate agencies and hold with one.

As we have de-levered, both on some OA debt as well as a little bit of our debt, and we expect to de-lever another tranche that's due in 2019 for us, we see the ability to drive back to our traditional BBB+ credit rating.

But to be clear on the second part of your question on the share repurchase, we were out of the market at the time of the acquisition.

That was not related to a leverage issue.

That was related to the fact that we were in the process of the acquisition.

We're in possession of material nonpublic information and could not, therefore, enter into a plan to execute on share repurchase.

We are pleased that the acquisition closed on June 6. And within a couple of days from there, we were able to get back into the market, and we continue to be -- and expect to be in the market on share repurchase as we look forward.

So quite satisfied with the leverage.

I do expect, as we grow the business, grow the cash, grow the EBITDA, we will continue to see that leverage number drop on us.

Your next question comes from the line of Ronald Epstein with Bank of America Merrill Lynch.

Maybe a question for maybe both Kathy and Wes.

Now that you have the OA assets within the Northrop family, how do we think about the opportunities in front of you in classified space, hypersonics, that kind of thing?

Because it seems like strategically, those assets put you in a better position to win some of that work than had you not had them.

So Ron, this is Kathy.

I'll start and then Wes can add in.

You see it exactly the way we do.

We see clear opportunity for us in jointly pursuing opportunities in space, hypersonics, precision munition.

These are areas where the portfolio, in bringing together IS with the rest of Northrop Grumman, we clearly see synergy.

And just as important, we see the opportunity to really shape where those markets go through innovation and increased affordability, the cost synergies that we'll generate in bringing the teams together will also contribute to our competitiveness.

So on all of those dimensions, we see that we are now able to offer more options in the markets I mentioned as well as others.

And that will be our primary sources of revenue synergy, which creates value over the long term from bringing the IS team into Northrop Grumman.

Yes.

And I would just completely agree with what Kathy said.

I think this is turning out to be just a wonderful bringing together of two companies.

The only thing I would add is I've just been delighted to see the very nice culture match and the almost instant desire on the part of all of the individuals involved in this on -- with respect to both of the companies came together to start getting together and creating new ideas.

And new ideas are the source of value creation.

That's how, over the longer period of time, we're able to better serve the customer.

And I think that's what the customer is expecting of us, quite frankly, as we bring the companies together.

So I'm really excited about that because we're already seeing that those connections being made and those ideas beginning to be generated.

So I'm very optimistic about what this will mean.

Your next question comes from the line of Rajeev Lalwani with Morgan Stanley.

Kathy, Ken, just a question for you on the Aerospace margin side.

You had some nice trends here in the quarter and I think year-to-date.

I mean, does this create a runway to maybe getting back to the low to mid-teens as we look forward over the next couple of quarters and years?

Rajeev, I'll start and then ask Ken to add in.

But what I see is just really strong performance on the part of our AS team.

The blocking and tackling that goes into good solid program execution is what is leading to the margin improvement, and we clearly see that potential to continue.

We incentivize the team clearly to continue to find opportunities for program performance improvement that leads to margin expansion.

And so what we are seeing is a clear result of that alignment of the team's objective to our shareholder objectives, and we expect it to continue.

I'll let Ken speak a bit more on the details.

Yes, I would say that we've seen mix as being the single-largest impact on our margin profile at AS in terms of the lower margins over the last couple of years.

To Kathy's point, I think we've seen that the sector is also performing on its portfolio of programs, both on the production and the development side and is driving its performance up.

I will just say that as we look forward, some of the larger development opportunities could be at the aerospace sector.

And if we are to take on some more mix challenge in terms of some additional development programs, then we could see some additional pressure on margins -- margin rates as we look forward.

But with a significant growing top line that AS has had, we have seen nice growth in margin dollars even with some of the rate compression over the last couple of years.

And Rajeev, just to make sure we're all in the same page in terms of your question, you referenced sort of low teens.

I would just say if you look back historically, AS has tended to run in the 12s.

And certainly our benchmark for AS is 11%, and we incentivize them to do better than that.

So just to kind of level set us all on where AS has been and make sure we're all on the same page there.

Your next question is from the line of Peter Arment with Baird.

Wes, best of luck on everything.

Kathy, can you maybe give us -- you mentioned some consolidation at TS.

Do you anticipate any portfolio shaping out of that?

Or maybe just give us some update how you -- the time line looks for when that actions will be completed?

Yes.

So the new structure at TS is aimed at creating a better-focused organization on innovation and affordability.

And we are implementing that at the beginning of 2019.

As many of you know, we've been on a journey over a couple of years to eliminate the majority of the commodity-based services work that we have in the TS portfolio.

And next year, it'll continue to be somewhat of a tough compare as we had VITA in the portfolio through most of third quarter this year.

But the logistics business at TS is growing.

All segments of TS are winning new work, and those new programs are achieving strong margin rates.

So we really see that we'd now have a services business that has a solid foundation for growth in the long term and healthy program performance.

And so that's really what we're working to optimize through this restructuring that we'll do at the beginning of January and will go from three divisions down to two.

Your next question comes from the line of Sheila Kahyaoglu with Jefferies.

Wes, congratulations.

Thanks, Sheila.

Kathy, in your prepared remarks, you mentioned a whole host of opportunities of program progress.

I guess, how do you think about the longer-term growth profile of Northrop?

And just outside of F-35 and restricted programs that have been a significant driver, maybe some opportunities you could point to or significant areas of higher growth?

Yes.

Thanks, Sheila.

So I made the comment about our growth prospects in the comparison to the investment accounts, which are what we typically think of as a proxy for our growth.

And when I think about over the long term, I talk to multiple years.

And so many of the things that we're pursuing are awards in the 2020 time frame.

And to give you a few examples of U.S., we have both for the OPIR programs, the GEO payload as well as the OPIR Polar satellite program in our pipeline.

We were sole source awarded the OPIR Polar, and I talked about the GEO payload program down-select that will be made in 2020.

We also have a number of restricted space programs that -- and any one of them isn't as material as the collection of the handful that we are pursuing.

We also have several full-rate production programs for the next 2 years.

I talked about G/ATOR and CIRCM and IBCS all in my comments earlier.

Those are all in Mission Systems, but all represents significant full-rate production awards in the next 2 years.

We are competing for down-select in a number of areas.

I talked about OmegA today.

You all know we are competing for GBSD and have made it through the first down-select.

And we also have been down selected on Next Gen Jammer load band.

So all of those are competitions that we'll pursue over the next couple of years.

And so as you can see, it's across all of our businesses: aero, Innovation Systems, Mission Systems and Technology Services that we have a robust pipeline as well as, as you noted, the growth that we have on current programs that are still ramping up to their full potential, like F-35.

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

This is an offbeat question, I suppose here.

But Wes, I'm kind of curious to know what's next for you?

Where might we see you next?

What are you passionate about?

Are we going to hear from you again?

Unlikely that I'll just disappear.

But I have a number of things that, outside of our industry, that are of great interest to me, both on a personal level and, hopefully, in terms of being helpful to others.

I'm going to take a little bit of time to sort all those things out, to figure out exactly where I want to focus my energies and my passion.

But I'm looking forward to the opportunity to do that.

And I very much appreciate the question, Hunter.

It's been just a lot of fun to be involved in this for so long.

But hopefully, I can find some other good things to do that will be helpful to others.

Your next question comes from the line of Rob Stallard with Vertical Research.

First of all, the best to the future, Wes.

Hope you have a good time.

Thank you.

And then secondly, Kathy, you mentioned the very strong year-to-date growth in export markets.

I was wondering how sustainable do you think that growth rate is looking forward.

Rob, we see that growth rate as sustainable in that a number of the opportunities we are pursuing, including Global HALE as well as then sustainment for those products that we're delivering, to continue a strong pipeline there for other countries that are seeking that capability as well as additional units.

I spoke today specifically about also the E-2D growth that we're seeing in Japan.

And we anticipate that,that kind of growth will also continue worldwide.

And so those are just a few examples that across all of our areas, Space, cyber, autonomous, Manned Aircraft as well as the sensors that go on those aircraft, we are still seeing strong growth potential in particularly Asia Pacific but also some notable programs in Europe.

Your next question comes from Sam Pearlstein with Wells Fargo.

I was wondering if you could talk a little bit about performance.

You didn't -- I guess, one is, can you give us an update on some of the programs from last quarter, so the James Webb and the Advanced Capabilities program?

And despite no, I guess, headline performance issues in the release, the unfavorable EACs did move up to $147 million in the quarter, which is up from last quarter.

Can you -- are there any particular issues you can highlight that might have been behind that?

Sure, so let me maybe start with the second part of the question and then Kathy can comment on the programs.

I would say from a negative EAC perspective, there's nothing there that I would point to.

I would remind you that in the second quarter, some of those -- some of the adjustments that we referenced were not recorded as negative EAC adjustments because they were with respect to options that had not been exercised.

And therefore, some of those margin headwinds were not in that negative adjustment chart.

And looking at the performance for the quarter, we're quite satisfied.

All of the sector's performing well.

We do have a large and diverse portfolio of programs that are always going to have some ups and some downs, and we try to take a solid approach to booking rates, not exceedingly conservative but not exceedingly optimistic, middle-of-the-road.

And that's going to mean you're going to have some ups and downs, particularly with the program that's as diverse and, quite frankly, complicated as ours.

And so no concerns.

And on the programs themselves, I would just say nothing to comment on negatively from a performance perspective.

And with that, I'll turn it over to Kathy.

Quite the contrary, we have good performance closing out the contract on VITA, and so that process has gone exceedingly well.

We also, on James Webb, have been executing according to the plan that we laid out earlier this year in conjunction with NASA.

And the team is progressing through INT quite well.

So on both of those efforts, we have delivered just as we anticipated through the third quarter.

Your next question comes from the line of David Strauss with Barclays.

Ken, I think a question for you.

Wanted to ask about how we should think about free cash flow conversion from here.

Looks like this year, you're going to be in the 70%, 75% range.

All the different moving pieces going forward in terms of CapEx, working capital opportunity, pension, all of that, how we should think about that trending from here?

And then a real quick one on pension.

I get why the FAS side gets a little bit worse than what you were expecting previously.

But it looks like you took 2020, the CAS number higher.

Can you just talk about what's going on there?

And I think you've also said that you would expect CAS to actually go up kind of in the 2022 time frame.

Sure.

Appreciate the question.

From a free cash flow conversion perspective, I guess, I would say that when you have some of these items, like we had in this quarter with respect to the cost claim, and we certainly had some tax items that are not necessarily going to result in cash tax savings in the year.

They result in some future opportunities for cash, you can get some lumpiness in your cash conversion percentage.

I think the important thing to focus on is the ability of this business to generate cash as we look forward.

And this should be a business that generates a strong, both operating cash flow as we look forward, as well as free cash flow.

And largely, I would say our free cash flow conversion should be increasing as we look forward.

In particular, if you exclude some of the onetime items we've had this year as well as over the past couple of years in terms of some either margin or tax benefits.

And then also, as we look forward, we've mentioned that 2019 should be the -- another year of kind of heavier capital expenditures.

And we should start to see that moderate, both as in dollar terms and in percentage of sales terms as we look forward.

So that should help from a free cash flow conversion perspective.

Additionally, going to your question on CAS, I would say that CAS is certainly less sensitive to a number of assumptions than FAS is.

But when we see -- as we mentioned this year, we've got, call it roughly breakeven returns through September 30, that will result in some increased CAS as we look forward, and I think that's what you're seeing on the 2020 CAS line.

And I would say that pension should continue to be something that is not necessarily a headwind for us from a cash or free cash flow perspective.

We continue to see a profile where our CAS should be in excess of our required funding.

So overall, it is -- this should be generating a fair amount of cash as we look forward.

And I would say our conversion should be strong, although we always look to continue to drive operating excellence even when that means the cash might trail a little bit of time just managing all aspects of the business.

Your next question comes from the line of Cai Von Rumohr with Cowen and Company.

So Lockheed Martin increased their sales guide for this year and for next year, and they cited the fact that the FY '18 budget got done early.

We have an FY '19 budget early.

Congress threw some more money in the pot for the F-35 and the F-18 programs, on which you also are a participant.

As you look at next year, do you -- does your revenue growth look better today than it did 3 to 4 months ago?

So Cai, I'll take that question.

And I'll also remind you that we'll give you full guidance at the end of the fourth quarter call in 2019, in January 2019.

But as we are approaching the end of this year and looking forward into '19, I mentioned that our programs have been well supported in the '19 budget.

And we do feel as if we will continue to see the kinds of growth that we have experienced in '18 into '19.

And we will reduce some of the headwinds that we've had, particularly in Mission Systems, with the two programs that Ken noted.

And we will start to get through the headwinds that TS has seen through the three programs that we have noted throughout the call this year.

So in terms of compares, we will be in a more favorable place as we head into '19.

But I will also state that the growth that we have seen historically going into '17 to '18 was very solid.

So we continue to grow off of prior years of strong growth in the sectors as well.

And Ken, I don't know if there's anything you'd like to add there.

Well, I think you hit it on point there, Kathy.

And it's right that we have seen -- again, we have a diverse portfolio and there's always going to be some ups and some downs.

And we've seen some programs that have been working their way out of the system this year.

Some of those will have a little bit of impact in the early part of next year, but largely should work themselves out of the kind of the compare from year-over-year in the earlier part of '19.

And I'm with you.

I think we really feel like we have the ability to grow this business and feel very positive about how we're positioned.

Your final question comes from the line of Doug Harned with Bernstein.

Wes, I am sure you're going to find plenty of good things to do but we will miss you here.

Thank you, Doug.

Thank you.

I have a question about the Orbital acquisition.

And as you set up the Innovation segment, where you've got three groups there, and when you look over time to really get synergies with Mission Systems and with Aerospace, one would think you've got to change that organization around or these organizations around significantly to optimize that.

So the question is, how are you thinking about evolving these organizations and in terms of the kind of the things you need to pull together to get the most value out of them?

And what kind of time frame are you looking at for that?

Thanks, Doug.

So clearly, my primary focus over the course of '19 is to make those evaluations, look at the portfolio.

We are, as I said, developing our revenue synergy opportunities.

And those will inform my thinking about how we need to ensure we operationalize and organize to execute on those synergy opportunities.

But what I also value in bringing that team in as a stand-alone sector is the transparency that we will get as we work our way through '19 around the cost synergies, that we want to achieve full run rate of by 2020 as well as the opportunity to make sure we are implementing the best of both model that we have established there.

There is a lot for Northrop Grumman to take in terms of value from the way Innovation Systems operates, and likewise, the opposite is true.

And so we have had this best-of-both mentality.

We're executing on a well-thought-out integration plan to help us achieve that.

And so really, I want to focus the better part of next year on realizing those cost synergies, executing on best of both, ensuring that they have solid operational performance, and then look through the revenue synergies to inform my thinking about any changes that we might make.

Thank you.

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

All right.

Well, thanks, Steve.

I'd asked Steve to save me a little time at the end of the call so I can say a few words as I wrap up my last earnings call with the company.

I want to take the opportunity to publicly say thank you to the amazing team at Northrop Grumman.

It's a humbling experience to work with so many brilliant people, who are absolutely committed to serving our customers and advancing global security.

I will tell you that this team rises to every challenge, and it is critical that we do as those we serve, our customers around the globe, are people we genuinely care deeply about.

I'm grateful to have had the opportunity to work with such incredible people in our company and in our customer community.

And it's been a real privilege to serve in so many roles in our company over the years and especially in the roles where I've had a chance to engage with the community of analysts and portfolio managers.

I've sincerely enjoyed working with all of you in the financial community ever since I became CFO way back in 2005.

The research that you perform, the questions you pose and the objectives you help frame really do make our companies better.

I sincerely value what you do and how you do it, and I want to express my appreciation for the opportunity to work with all of you for so many years.

So while looking backwards is important to do periodically, I'm actually more excited about looking forward.

Our company is fortunate to have an exceptional leader as our new CEO, and I'm confident that the best years for Northrop Grumman are the years ahead of us.

So thanks for joining us on the call and thanks for your continuing interest in our company.

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

Thank you for your participation.