Northrop Grumman Corporation (NOC) Q2 2010 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Welcome to the Northrop Grumman Second Quarter 2010 Earnings Conference Call. My name is Laticia, and I will be your operator for today. [Operator Instructions] I would now like to turn the call over to your host for today, Mr. Paul Gregory, Vice President of Investor Relations. Please proceed, sir.

Very good. Thank you Laticia. Good morning, everyone, and welcome to Northrop Grumman's Second Quarter 2010 Conference Call. We provided supplemental information in the form of a PowerPoint presentation that you can access at www.northropgrumman.com. Before we start, please understand that matters discussed on today's call constitute forward-looking statements pursuant to the 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 and may cause actual company results to differ materially. During today's call, we'll discuss second quarter results and our guidance for 2010. We will refer to non-GAAP measures, which are defined and reconciled in our earnings release and the supporting materials posted on our website. Our results for the quarter reflect the net benefit of this quarter's $296 million tax settlement and our announced plans to consolidate our Gulf Coast Shipbuilding operations. In addition, results for all periods reported reflect the TASC divestiture, which was completed in December 2009 as discontinued operations. On the call today are our CEO and President, Wes Bush; and our Chief Financial Officer, Jim Palmer. And with that, I think we're ready to turn the call over to Wes. Wes?

All right. Thank you, Paul. Good morning, everyone, and thank you for joining us. This morning, I'll discuss our second quarter results, operational highlights and our outlook for 2010. We're very pleased to report another solid quarter that demonstrates our commitment to delivering sustainable performance improvement across all of our businesses. Sales rose 3%, and our segment operating income increased 14%. Earnings per share of $2.34 includes $0.73 for the net benefit of this quarter's tax settlement and the Shipbuilding consolidation-related charge. Before these items, our second quarter earnings per share increased 42% to $1.61, driven by higher sales, higher segment operating income, lower net pension expense and a reduction in shares outstanding. Before the consolidation-related charge, all five of our businesses generated higher operating income and a higher margin rate than in the prior-year period. Aerospace, Electronics, Shipbuilding and Technical Services also generated higher sales. The company's second quarter segment operating profit would have totaled 9.9% before the consolidation-related charge, representing underlying margin rate expansion of nearly 200 basis points. EPS growth also benefited from a lower share count. During the second quarter, we repurchased approximately 6.5 million shares of our common stock, bringing this year's repurchases to 14.8 million shares for approximately $850 million. Based on our performance through the first half of the year, we are increasing our guidance for 2010 earnings to a range of $6.60 to $6.80 per share. Turning to cash, second quarter cash from operations and free cash flow totaled $619 million and $515 million, respectively. These results included the impact of the $300 million discretionary pension plan contribution we made during the quarter. We're lowering our cash guidance for the year, principally to reflect the anticipated cash impacts of the wind down of ship construction at Avondale. We now expect that cash from operations will range between $2.3 billion and $2.8 billion, and free cash flow will range between $1.5 billion and $2 billion. Guidance for both these metrics is before discretionary pension contributions. Our updated guidance for cash reflects the impact of the consolidation decision and a strengthening of cash flows in the second half of the year, and Jim will provide more detail on cash later in the call. During the second quarter, we also continued to execute our balanced cash deployment strategy. This included the previously mentioned pension contributions and share repurchases, a new $2 billion share repurchase authorization and a 9.3% increase in our quarterly dividend. Going forward, we remain committed to a balanced cash deployment strategy that calls for investing for the future, managing liabilities and returning cash to shareholders. At the end of the second quarter, we had a total backlog of $66 billion, which reflects new awards of $6.5 billion in the quarter. Moving on to sector highlights. Aerospace sales increased 6%, operating income increased more than 30% and margin rate improved more than 200 basis points to 11.8%. We also had several notable awards, including a competitive Army award with potential value of up to $517 million to develop up to three Long Endurance Multi-Intelligence Vehicle systems or LEMVs. LEMV is another example of our ability to meet an urgent customer need, with an innovative solution that's flexible and rapidly deployable. This program will leverage our core competencies in unmanned air systems, C4ISR and systems integration. The design allows for plug-and-play sensor payloads and can be readily integrated with the Army's existing ground station command centers. The LEMV will have the flexibility to operate optionally manned or unmanned, and will provide unprecedented dwell capability over theater. Also in the unmanned domain, Euro Hawk successfully completed its first flight, and we received the DARPA [Defense Advanced Research Projects Agency] award to develop and demonstrate air-to-air refueling of high-altitude unmanned systems. Under the contract, we will modify an existing Global Hawk to access a tanker to fuel another Global Hawk. This is an important step in the evolution of unmanned technology, and our successful demonstration of this capability will further strengthen our strong position in the unmanned domain. Aerospace Systems was also awarded $260 million for Global Hawk, which continues to make tremendous in-theater contributions to our nation's war fighters. We share our customers' concern regarding costs in the program, and we are working closely with the Air Force to address their affordability constraints. During the quarter, Aerospace also received awards of $200 million for F-35 and $135 million for F/A-18. Electronic Systems sales rose about 1% for the quarter, operating income increased more than 5% and margin rate expanded more than 50 basis points to 13.3%. An important highlight in the quarter was the successful inaugural flight of the mission systems on F-35. Electronic Systems' new Active Electronically Scanned Array radar performed very well. The F-35 is also equipped with our Electro-Optical Distributed Aperture System, which provides passive missile and aircraft track detection, as well as infrared day and night vision that is projected directly onto the pilot's helmet visor for a fully spherical view around the aircraft. This is the first time the F-35 has flown with mission-enabling sensor systems, including the fire control radar from Electronics and the integrated communications, navigation and identification avionics from Information Systems. Information Systems sales were slightly lower than last year, but operating income increased 26% and margin rate expanded more than 200 basis points. Backlog at IS increased more than 15% to $10.1 billion, which reflects the completion of the Commonwealth of Virginia's review period for our new agreement on the VITA [Virginia Information Technologies Agency] program. We continue to make solid progress on VITA, and we believe that our risks going forward on the program has been reduced. Another second quarter highlight was being selected as one of four companies to receive contracts in all areas of the National Geospatial-Intelligence Agency's TASER [Total Application Services for Enterprise Requirements] program. This ID/IQ [indefinite delivery/indefinite quantity] contract with a $1 billion ceiling provides for timely and innovative solutions to critical geospatial intelligence requirements. Sales at Shipbuilding increased 5%, and as a result of our decision to consolidate future new construction in Mississippi, we recorded a charge of $113 million, which resulted in a $16 million operating loss for the quarter. As I said during our conference call to discuss the strategic actions of Shipbuilding, the consolidation-related charge of Shipbuilding does not reflect performance deterioration on the Gulf Coast. Before the charge, Shipbuilding's second quarter operating income and margin rate totaled $97 million and 5.7%, respectively. And for six months, totaled $203 million or 5.9% of sales. So Shipbuilding was on track to meet or exceed our prior margin rate guidance. Shipbuilding ended the second quarter with a total backlog of $18.4 billion. During the quarter, we received advanced procurement contracts for the LPD 26, LHA 7 and DDG 114. We were also awarded a contract for additional effort on CVN 78. Together, these Navy contracts totaled more than $600 million. At Technical Services, sales rose 14% during the second quarter, operating income increased 21% and margin rate expanded to 6.5%. The solid sales growth in TS is being paced by the continued ramp up on logistics programs such as the KC-10 and C-20, which are key contracts we were awarded last year. Shortly after the close of the quarter, the State Department awarded Technical Services a five-year $150 million ID/IQ contract to continue to support to the African Contingency Operations Training and Assistance [ACOTA] program. While we continue to have solid new business opportunities across the company, both we and our customers recognize that we face a challenging environment going forward due to the economic environment and the federal budget deficit. We fully support the efficiency and affordability initiatives that OSD leadership is bringing forward. We also appreciate the opportunity that industry is being given to participate in the definition of these initiatives. The 2011 budget is still evolving. There is a high probability that we may have to operate under continuing resolution for some period of time before the budget is finalized. Both the House and Senate Authorization committees have proposed reductions and modifications to the President's budget, and convergence is likely to take some time. To date, our programs have generally been well supported, and we expect that to continue to be the case. However, an expanded continuing resolution would impact the timing of awards and delay new starts. While not an entirely new situation, clearly the fiscal environment going forward will be challenging, and the competition for funding even more intense. We've been proactively positioning Northrop Grumman to compete and succeed in this environment, and we remain keenly focused on driving continuous, sustainable performance improvement and efficiency throughout the organization. Our actions over the last few years to consolidate eight sectors into five have been important steps in this direction. The move of our corporate office to the Washington D.C. area will also provide an opportunity to reduce costs. And our recent Shipbuilding announcement was another important step. The decision to consolidate future new ship construction in Mississippi was difficult, but necessary to ensure long-term improvement in Gulf Coast program performance, cost competitiveness and quality. This decision was also aimed at aligning our capacity with future Navy plans and improving future efficiency and affordability. I know that many of you are very interested in our process for exploring strategic alternatives for Shipbuilding. As I indicated in our call a couple of weeks ago, our primary focus will be on a spin-off to shareholders, but we also will assess a sale. We are just at the beginning of this process and until we announce our final decision, we don't plan any further comment on this process. So now I'll turn the call over to Jim for a more detailed discussion of the financials and more color on our outlook for the remainder of the year. Jim?

Thanks, Wes, and good morning, ladies and gentlemen. During my comments, I'll provide additional detail on sector results, cash performance and our guidance for the year. I just want to reiterate that it was another good solid quarter. As Wes said, excluding the net benefit of $0.73 from the IRS settlement and the consolidation-related charge, underlying EPS growth was 42%. Operating margin coupled with higher sales, lower net pension and a reduction in the share count was the biggest growth driver. Sales increased 3% and even with the consolidation charge, segment operating income increased by 14% and total operating income increased by 17%. Through the first six months, segment operating income was up 10%, and total operating income has increased by 20%. These positive trends largely reflect improved operational results as well as lower net pension expense, but partially offset by higher corporate unallocated expenses due to the $64 million favorable legal adjustment in last year's second quarter results. Now let's turn to the sectors for a little bit of discussion. Through the first six months, Aerospace Systems sales are up approximately 8%. Aerospace sales performance continues to reflect the overall strength of our unmanned and manned aircraft programs like Global Hawk, BAMS, F-35, B-2 and the EA-18G, as well as some restrictive work. The positive trends for these programs were partially offset by the KEI cancellation and lower volume for our ICBM program. You'll recall that last quarter, we mentioned that the NPOESS program is being restructured. We continue to work with the Air Force and NOAA [National Oceanic and Atmospheric Administration] on a path forward for this program. We now expect some resolution during the second half of the year. So while the restructuring has not affected results through the second quarter, it could impact the second half results. Aerospace second quarter sales were again accompanied by a very strong operating income. For the quarter, margin rate expanded to 11.8%, and through the first six months, margin rate has expanded by about 140 basis points to 11.4%. The improvement in second quarter results reflects improved program performance across a variety of programs, especially in manned aircraft platforms where we increased our margin rates on several programs due to risk retirement. As a result of the strong performance through six months, we now expect the margin rate in Aerospace of approximately 11% for the year while sales growth of about 5%, depending on the outcome and the timing of the NPOESS restructuring. Electronic Systems' sales were slightly higher for the quarter and through the first six months, sales were in line with our guidance at 2% to 4% growth. ES generated a 13.3% margin rate for the quarter, which reflects improved program performance in targeting systems programs and land and self protection systems. These performance improvements were partially offset by lower performance for postal automation. Through six months, ES generated a margin rate of 12.7% comparable with last year and consistent with our guidance for the year of mid to high 12%. For Information Systems, second quarter sales continue to reflect the planned declines in civil revenues as well as a slight decline in volume for intelligence programs. These areas were partially offset by higher volume in our Defense programs. The second quarter trend for intelligence principally reflects lower volume for the Counter-Narcoterrorism program and the loss of the GPS OCX program. Through six months, Information Systems' sales are down about 1%, and I would speculate that there's some risk through our 2010 sales guidance of 2% to 4% growth due principally to delayed awards and the potential impact from an extended continuing resolution that Wes mentioned in his comments. I would also note that in the second quarter, operating income included risk retirement related to a subcontractor on our New York City Wireless program. Some of you may recall that in the third quarter of 2008, we took a charge on this program, part of which related to subcontractor risk that has now been retired, resulting in $18 million being reflected in this quarter's operating income. Excluding this item, IS had an operating margin rate of 8.8% for both the quarter and for the six months, which is a little bit better than our mid-8% guidance for the year and represents good solid performance improvement over 2009. Shipbuilding sales increased 5%, reflecting higher volume for aircraft carrier, submarine and expeditionary warfare programs. The increase in estimates to complete the LPDs 23 and 25 through a consolidation decision resulted in about $115 million reduction in sales for the quarter. Operating income reflects the impact of the consolidation-related charge, and I would reiterate Wes' comments that excluding that decision to consolidate Gulf Coast construction, Shipbuilding was on track to meet or beat our guidance of 5% to 6% margin rate for the year. As a result of the consolidation decision, we now expect an operating margin rate of 4% to 4.5% for Shipbuilding on a sales base of about $6.3 billion for the year. Technical Services had a 14% sales growth, with an operating income increasing by 21% to 6.5%. Through six months, sales were up about 17%, operating income is up 26%. Higher operating income and rate reflect the volume increases as well as a more favorable business mix, with logistics representing an increasing share of sales this year versus last. While we continue to expect a low- to mid-6% margin rate, we now expect low double-digit sales growth with frankly the biggest variable being ID/IQ task order levels over the balance of the year. Turning to cash, operations generated $619 million, and free cash flow totaled $515 million. And during the quarter, we made discretionary pension contributions of $300 million. So before this contribution and recognizing the tax benefit of those contributions, operations generated $895 million and free cash flow would have been $791 million. As many of you know, the first half of our year is typically lower than the second half. In addition to those seasonality impacts this year, we did experienced some working capital growth during the first half of the year, driven by higher sales volume and less efficient collections in some areas. In addition, last year's first half cash flow results included about $100 million for discontinued operations, principally related to the TASC operations. So we now expect cash from operations of $2.5 billion to $2.8 billion for the year, and free cash flow of $1.5 billion to $2 billion. This range is before the impact of discretionary pension contributions, and the modest adjustment to our cash flow guidance principally reflects impact of the Shipbuilding consolidation decision. It really doesn't reflect any fundamental change to our operating performance or our underlying cash generation. At this point, let me also briefly comment on our outlook for pension expense. The sensitivities that we've talked about in the past that I provided for changes in discount rate and variance around our expected investment performance are unchanged from what we talked about at the beginning of the year. Just to reiterate that, holding all assumptions constant, 100 basis-point variance to our 2010 expected rate of return of 8.5% is about a $40 million change in 2011 FAS expense. And a 25 basis-point change in the year end discount rate assumption for our liabilities, which was 6% for 2010, will generate about a $75 million change in our 2011 as pension expense. As I think all of you know, our plan assets are mark-to-market at the end of the year, and we will really not know what our FAS/CAS pension adjustment will be for 2011 until the end of the year. I should also comment that through the end of the second quarter, client investment returns were positive, it's about 2%, and they have improved with the market during July. So in conclusion, results for the first half of the year support an outlook for continued operational improvement. We've modestly increased our sales guidance to $34.8 billion, and our new guidance for earnings from continuing operations is $6.60 to $6.80 per share. Our outlook for cash calls for a strong second half that will be reduced principally by the strategic actions we are taking at Shipbuilding. Paul, I think with that, we're ready to begin our Q&A session.

Outstanding. Thank you, Jim. So Laticia, I think we're ready to go to Q&A, and I would remind everybody to try to limit your questions to one if you could and let's go ahead and start.

[Operator Instructions] Your first question comes from the line of David Strauss of UBS.

Wes, with the potential spin out or sale of ships, how does it change the value proposition as you think about Northrop? You've talked about execution being a big part of the value proposition. Just how does it change as you think about the potential spin off of ships?

Well, I think that if anything, it reinforces that value proposition. As I've said a number of times of late, we are very focused on driving sustainable performance improvement in all of our businesses. We continue to see some upside in the margin generation potential of those businesses. We continue to see strong cash generation, and I believe our approach to deploying that cash over time has demonstrated a focus on our shareholders and will continue to enable us to generate value from those deployment decisions. So I don't see any fundamental change as a result of that decision with respect to the way we're driving the business and the objectives we're trying to achieve.

And then on F-35, with Lockheed talking about potentially taking a fixed-price incentive contract for LRIP Lot 4, how would that potentially impact you as the major subcontractor on that program?

We're going to look at that on each of the individual areas where we are a subcontractor. It spans across three of our sectors. We provide support, subcontract support to Lockheed from Aerospace, Electronics and Information Systems. We will, in each of those sectors, look out where we are in the production cycle in terms of our cost confidence, where we are in terms of the learning curves, if you will. And work that through with Lockheed to see what makes the most sense. One of the things that I think is important to continue to emphasize is, generally, when we're well into production, our company has done quite well on fixed price work, where we're generally positive about a view of fixed price work in production. The question is at what point do you move into that as we go through these early stages on LRIP. And it's always a little bit different from subcontract to subcontract. So we're going to manage that on a case-by-case basis.

Your next question comes from the line of Sam Pearlstein of Wells Fargo Securities.

Wes, can you talk a little bit about your views towards capital allocation? We've, I guess, know about the ship side. We have been thinking, I guess, that the share buyback pace would slow is what you've said in the past after you redeployed the TASC proceeds, and yet it stayed relatively high. Can you just talk about your view towards share repurchase and other capital allocation as we go forward?

I think what we were trying to do when we got through the TASC, the use of the net tax proceeds from TASC, was to make it clear that we've been on a rate of share of repurchase through that time frame to meet our commitment to use those shares, use those proceeds in that way for repurchase. We continue to look at share repurchase as a very good use of cash in the company. And as you note, Sam, we've continued to buy back. We do modulate the rate of repurchase based on the share price that we see in the marketplace, and we make decisions on what that rate looks like each time we enter into a share repurchase program. And so with the overall marketplace being down a bit over the last few months, that has increased the rate at which we have repurchased. But I would say as we go forward, we continue to see share repurchase as a very good use of our cash. You probably noticed that we announced a new authorization, a $2 billion authorization that our board recently approved. And that should be taken as a signal that we'll continue to see share repurchases at good approach.

If I might, I would just add that in addition to returning cash to shareholders, our approach towards a balance cash deployment continues, whether it's managing the liabilities or investing in the business through capital or through potential acquisitions. So really no change, Sam, to any of our approach here. Steady as it goes.

When I look at your free cash flow for the year, is there anyway I should think about how that cash will be deployed? Obviously, dividends, we can calculate relatively easily but in terms of just stock purchases in the second half?

As you know, Sam, we don't give that kind of guidance.

Sam, to Jim's earlier point, when we do think about managing the liabilities, obviously, pension is a part of our thinking. And I think we've been pretty clear that we look at that carefully to make sure that we're doing the right thing for the long term with our pension plans as well. So I would just add that to the thought process.

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

I'd like to understand a little more about what's going on in the Information Systems. I know your backlog is up a lot. Wes, you mentioned the VITA contract. And then Jim, you referred to the margin, both the margin levels now and also the potential for slightly lower sales than you expected over the course of the year. Could you describe all those moving parts in a little more detail?

Sure. On the sales side, what I tried to say was that given the very likely continuing resolution, there could have an impact on the sales cycle at IS. As you know, the sales cycle there is shorter than in many of our other businesses. And so a continuing resolution that could delay the start of new programs could have an impact on awards, and therefore, sales for this year. In terms of margin, I just tried to point out that the margin rates for this quarter were very strong, reflecting not only good performance, but also the resolution of the subcontractor issue that we took a charge for in the third quarter of 2008. That was $18 million favorable for the quarter, and that reduced margin rates for -- if you take that out, that would reduce margin rates in IS down to about 8.8% consistent with where we were for the six months period and basically, a little bit better than our guidance for the year. So what I really see out of that Information Systems' guys this year is good. Strong performance in managing their business, and then we have the sales cycle issue that we talked about.

But is the VITA contract the source of the added backlog? And also, if you had the reduction in sales, can that actually help margin for the year?

Depending on which programs that it comes from, yes, it could. Hard to speculate at this point, and you're correct that a big part of the backlog increase was VITA related.

Doug, the other thing I would say about the backlog and IS is that actually we're seeing it increasingly in some of the other businesses, more and more contracts are moving over to the ID/IQ construct. And as you know, the way we approach that, we don't book the full potential value of an ID/IQ contract. We just look at it as the orders come in, and IS is a business that has a fair fraction of its overall business that derives from ID/IQ.

And your ID/IQ piece is growing as well separately?

Yes. ID/IQ revenues are clearly growing.

Yes.

Your next question comes from the line of Howard Rubel of Northrop Grumman (sic) [Jefferies & Company]. Howard Rubel - Jefferies & Company, Inc.: Wes, you've done a number of things that have broken the mold. And so part of what we would expect is improved profitability for the entire enterprise. You've sort of talked about it, and that's the other part of the value creation. Where do you think you can take the profitability of the company?

Howard, as we talked a little bit about over the last number of quarters, we're really focusing on that on a business-by-business basis. We do a lot of thoughtful benchmarking in the marketplace. We look at where we believe we can drive additional efficiencies and how we can better approach our contracting. And I would go back to what we've been talking about as the way we see each of the businesses: Aerospace around 11% as we continue to drive forward; ES in the 13% range; IS in the 9% range; Shipbuilding in the 9%, 10% range; and Technical Services pushing that up to around 7%. So every single one of our businesses is driving hard to achieve those levels in the near-term, and over time, obviously, we'd like to see ourselves at the top end of the market space and even move beyond that. But in the near term, those are the things that we're really driving on. Howard Rubel - Jefferies & Company, Inc.: I think I agree with you, but those are sort of what I'd expect, and I mean, I realized they're a lot harder for you to do than for me to put in the numbers. But Northrop, given your mix of contracts, has typically balanced risk a little differently, and in order to take those levels up to higher sustainable margins, do you need contract term changes? Do you need the government to accept different ways of doing business so that this can happen? And is there anything, I mean, other than what you've done already which is nice, is there something else we can point to, to get to this new sustainable level?

I think an important part of it is a reflection of the state of the business. The last few years, we've been quite successful in capturing a number of major development activities, and generally, when you're in the development phase, your margin rate opportunity is a little bit lower. As we move into the production, Aerospace has a large number of examples of that, whether it's joint strike fighter, whether it's the E-2 program, the continuing production work on Global Hawk and the variety of unmanned systems. As we move into production, those are better opportunities. Clearly, we have to perform. We have to deliver on those improved opportunities, but those represent really good examples of the types of things that we see as driving ourselves in the right direction. The other thing that we've been doing obviously is working on the portfolio in Information Systems. We have been working hard to de-tune the parts of the portfolio that really don't represent great margin opportunities, state and local. IT outsourcing is a good example that. We're continuing to look at that throughout the portfolio. And obviously, we make some bigger announcements, but there are a lot of smaller things that we're doing that I would say we're not quite as public about that are better tuning the businesses to the way that they're pursuing new captures, with a stronger focus around profitability. We are walking away from things that might give us a nice run on the top line but really don't achieve what we're trying to do from a profitability perspective. And that's just a part of the mindset that we're taking as we're looking at improving the overall performance of the company.

Your next question comes from the line of Heidi Wood of Morgan Stanley.

We, this decision to divesting ships, it's really a huge inflection point in the history of the company. When we go back to when ships were acquired, the idea was to be a higher-order integrator of the service systems as systems of perspective, and there was the highlight at the time on the benefits of being a prime. So how do we think about what the new vision is that replaces it? What are you telling your people on the inside? Is it to be a preeminent C4ISR player, preeminent defense electronics leader? I appreciate your focus on execution, and that's terrific, but that's tactical. What's division as we think about it from the top?

We have talked about the areas of focus for the company, being C4ISR, cybersecurity, our manned and unmanned programs, as well as logistics. And that really is a product of going through our view of the marketplace where we see the opportunities in terms of where our customers are focused, but also to your point earlier about how we have been thinking about shipbuilding. Where we see opportunities to create value by bringing the different pieces of the company together to create offerings to our customer and to create levels of performance that we wouldn't be able to achieve with just individual business units, so when we thought about where the market's going, where those opportunities are to really bring the pieces of the company together, that's led us to a view of where to focus that I think we've been pretty public about. It led us to a view that shipbuilding really did not represent a high degree of synergy with the other parts of the company in addressing those bases, and that most likely, we could generate a higher degree of value by separating the pieces so that they can each focus on the areas where they see their best future opportunities. So across the company, that really is the message. That's where the focus is, but I would say, whether you want to call it tactical or not, the key message that goes with it is we're looking for good business.

How does new co Northrop x ship stock up in terms of percentage of sales when you go across Navy, Marine Corps, Army and Air Force?

I don't think we have that percentage broken out for a discussion yet. As we get into the next steps and looking at what the actual separation mechanism we'll use, I think we'll get a little more clear about that. But the one thing I would say is that the Navy will continue to be a very important customer for Northrop Grumman post the separation of Shipbuilding. We do a lot of really important work for the Navy across all of the other four sectors, whether it's the unmanned work we do in Aerospace, the sensor work that we do in Electronics, the command and control and cyber work that we're doing in Information Systems, and of course, a lot of the work that we're doing in Technical Services. So the Navy will continue to be a very, very important customer to Northrop Grumman.

Because when you think of the -- you have less than 10% of sales in Army, and then you're divesting out of some of the Navy, I thought it would make you somewhat more reliant on Air Force, but it sounds like, Wes, you still feel you're going to be reasonably stacked across between Navy and Air Force?

Navy, Air Force, and Army is an important part of our business and increasingly so as we look at opportunities to bring a lot of the capabilities that we have in Electronics and in Information Systems. The Army and then earlier in my comments, I mentioned LEMDE, the work that we're doing for the Army as well. So we see all the services as very, very important, and of course, the intelligence community continues to be an important part of our customer base as well going forward.

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

Was wondering if you could walk through the Aerospace Systems margins a bit, and apologize jumped in a little bit late, but did you mention any positive adjustments taken in the quarter? I know you're reserving some conservatism for the NPOESS outcome, but just wondering what the real underlying margin rate is there?

Myles, this is Jim. We had strong margin rates in many of our manned aircraft programs, so there were some earnings adjustments positive in the quarter. They were at a rate greater than what we had in the past, if you will, so that contributed to margin rate for the quarter.

So that the level of conservatism that you're holding back for NPOESS in the back half of the year. I mean, is that still the only downside to the back half of the year?

If you will, the conservatism is probably more on the sales side and the margins that then come with it. So essentially what I said is through the first half of the year, NPOESS has not -- the potential restructuring of the program has not impacted revenues or margins, but we do expect the restructuring to occur in the second half, and there could be some impact to the second half margins and sales associated with NPOESS. I would also point out that in Aerospace, we raised our guidance for the year to 11% from the mid-10% range, reflecting the strong performance to date, as well as the expectation for the balance of the year.

And then the only other one on Aerospace with respect to EMARS, what is your expectation for the schedule there, and also, are there other programs you can point to in terms of opportunities over the near term?

Yes, Myles, this is Wes. On EMARS, you know what, I've been careful not to get into the business of projecting award dates as there are so many different factors. We do know that the Army is focused on EMARS. It's a very important program, and we do see that most likely working its way to an award some time in the fall. So that's the schedule that I've been giving, one is working hard to support. Now we have a broad variety of opportunities across the company that we're addressing. If you look at the world of unmanned is a good example, continues to evolve. We see both increasing demands domestically and internationally. The unmanned programs are gaining broader attention and I think do represent some meaningful opportunities as we go forward. When I look at Electronics and the work that's being done to address a variety of new applications for the sensors that we have in Electronics, I think there are some very, very good opportunities, again, both domestically and internationally that we're seeing there on the radar side, as we continue to expand our focus on radars beyond, I would say, our more traditional airborne radar position to the work that we do on the ground and eventually over time for the Navy. The IRCM programs continue to get good support, and I think there's going to be good opportunities for that as well. Cyber is another area where we talked about the continued push to make sure that not only are the new cyber-specific programs put in place and getting underway, but also the application of cyber to other new program starts where cyber becomes an embedded part or an enabling part of those acquisitions. So we're seeing good opportunities, a good solid pipeline of business across our businesses. The one caveat I would put to that is what I indicated in my other commentary that a continuing resolution would likely dampen the rate at which awards could be made and certainly would impact the ability of our customers to get new starts put in place, just given the rules that go with operating in SCR environment. So we're being a little bit cautious in terms of sounding too optimistic from that perspective. That being said, we see a robust pipeline across all of our businesses.

Your next question comes from the line of Joseph Campbell of Barclays Capital.

I have a series of questions about the headquarters move, and I'll just rattle them off and then let you speak generally. Will the new Northrop headquarters look, feel and be different from the one that, say, Ron [Dr. Ronald Sugar] had or is it going to be just a few thousand miles closer to the customer? Are there any challenges or risks to highlight? Is somebody in charge of all of this or is it just sort of free flow kind of dates for starting and stopping? Is there a headquarter shrink so that you'll be leaving with less or are you leaving some functions in California that will make this hard to kind of understand? Are the people that you want to move accepting and then what rate and are people turning you down and causing difficulties? And how many people are you kind of getting rid of and not offering a job in the headquarters? So you don't have to answer them all, just kind of a sense of what it really is and how's it going and any numbers would be helpful.

Sure, Joe. it's Wes, and I appreciate the question because it is important. It's not a big part of our company, if you will. Our headquarters operations, a few hundred people out of the 120,000 employees we have in our company. So I don't want to overemphasize the importance of the move, but it is important. It's important from a lot of perspectives. One, it is important in terms of what we really want to be doing in driving the intimacy with our customers. And sometimes, I think that's misunderstood as, let's see, Wes wants to be in Washington or Jim wants to be Washington, but it really is about having our headquarters team more deeply immersed in total in our customer environment and being able to make better decisions and support our customers in an enhanced way as we go forward. And I would say that was really the primary focus as we thought about relocating. But to your point, it is an important opportunity for us to resize our corporate office. We are doing that. We've not been public about any numbers, and I won't go into that in great detail other than to say we are using this as an opportunity to address our broader affordability initiatives across the company. We've asked that of each of our sectors. This work, the hard work that's been done and the consolidation of our sectors has enabled us to take cost out of our overhead structures and how we're managing those sectors and the operating costs as well, and we should have that same expectation for our headquarters team. And so we're using this move to drive cost out as we do it. And of course, we're managing it like a program. We have a schedule and a whole set of milestones that we're using to get us in place. The target date for doing that is to have the team in place and operating over the course of next summer. Of course, we've targeted the summer as the best time for move for the families that would be moving. We do expect that we will be hiring here in D.C., yet, it's always difficult to get everyone to move, particularly when the headquarters has been in the location where it is for so long, a lot of deeply established roots. But at the same time, it's an opportunity to bring in some folks that I think can help us move forward. And we have some good announcements over the last few months of new members of the team that we're bringing on. And their arrivals will be timely in helping to build the teams that they want to have in place as when they just moved. So I'm pleased with how it's going so far, a lot of work yet to do in front of us.

Your next question comes from the line of Ron Epstein of Bank of America.

Wes, just a broad question for you. Since Northrop truly been kind of narrative [ph] to cutting edge of this push for efficiency with the moves that you've done at the shipyards, I mean, how would you characterize the DoD push for efficiency? I mean, do you think that they can really get out of the industry the savings that they want to get? And I mean, what else would you expect to see industry to do?

Yes, I appreciate that question, Ron, because I think it is going to take a lot of thoughtful engagement on both sides, both industry and government to address it. Consolidations I think are going to be a part of it in terms of really looking at the industrial base footprint as we go forward. Our action in shipbuilding is a good representative example of that. I think a lot of what's going to have to be done is related to how the government goes under contract as it tries to think about cost structures. And part of what I've been happy to see in this process is a receptivity on the part of those in government that are pushing on this to hear what they need to do to make it work. It's not all one-sided about. This is what industry has to do, and so when we think about how the government is making decisions, how it's buying, how it manages the oversight functions, those are all things that are in the mix that together, I think, can lead to some very good outcomes. I think we have to get to some outcomes with affordability and efficiency. I think it's incumbent on all of us to make this work, to not be blockers of the process and say, "Gee, it's been tried before, it didn't work before, it's not going to work again." I just don't find that to be a constructive way of engaging on this because we are in it together. We owe it to the nation and to our allies to do better, and I think we can. So I would put it in a category of yes, there are a lot of things we've got to do from an industry perspective, some of which you've seen already get put in place, others that I think are going to unfold as it become far more clear, how that the government is going to focus. But there are a number of things that our government customers are also going to need to do, and that will be a big part of whether or not this succeeds.

Your next question comes from the line of Jason Gursky of Citigroup.

I know you mentioned that you're working with the Air Force to address the cost issues on the Global Hawk. But can you characterize the nature of the disagreement there and maybe expected timing for the resolution of these issues and potential results, for example, before you see any delays or price cuts to the program?

Yes, let me characterize what I see going on with Global Hawk. It has been an extraordinarily successful program from the perspective of providing support to the war fighters that they desperately need. The capabilities of the platform itself, I mean, on the altitude at which it operates, the endurance that it demonstrates, the amount of payload that it can carry has resulted in it being a little bit of a victim of its own success. And that the requirements have continued to grow. Its flight time hours have continued to increase, and as a result, when all of those things happen, costs go up, whether it's cost for spares and theater support or it's cost for supporting all the new requirements. And over time, those costs add up, and you have to stand back periodically and look at it and say, okay, are we at the right place on that? Do we have the right balance between what we really need out of the platforms and what the cost is. That's kind of the process that we're going through with the Air Force right now. We have committed to the Air Force to go on working hard on the affordability part of this. We are doing that. I think it demonstrated some very good progress to date on some of the learning-curve initiatives that we have. There are other things we need to do. So I would characterize that as a set of actions underway, haven't reached resolution yet as to what it all means, so that's what we're doing now with the Air Force. And as we go forward over the next several months, I think that really is the timeline to have a good perspective on, okay, what does it mean for the program, what does it mean for the requirements on the program, what it mean for the production rates as we go forward? So we're sort of in process with the Air Force now.

Your next question comes from the line of Joe Nadol of JPMorgan. Joseph Nadol - JP Morgan Chase & Co: Wes, I have some follow-up questions actually on the Shipbuilding announcements. Just in retrospects, the kind of thinking about it a week or two later. You mentioned on the last call that you don't want to break the business up into two pieces, but I think you mentioned between that call and today, some time, I believe, last week that you may have interest from bidders in a sale rather than a spin. I'm just wondering why you wouldn't consider breaking it up into two pieces because it would seem to me that Newport is a more salable business given the cash flow profile, and that maybe you could sell that, but perhaps you could find a better prospect internationally to sell off the Gulf yard?

Yes, I think the perspective I would offer on that is two-fold. One, as we have brought the two businesses together two and a half years ago, that's when we started down this path, it has become clear there's a lot of benefit to the opportunity of the business to create value for whoever runs it and in terms of the opportunity to serve the customer. There's a lot of benefit in managing this as an integrated business, and that is the view that we're taking as we are looking at the strategic alternative. So as we said a number of times, our first path on the skyway for our strategic alternatives is on spend. And we are also considering the sale part of it, but we are very focused on the spend outcome for separating the business. And so that's really guiding our thinking to a very large extent. The other part of it that I would point out here is that we have a strong commitment to make sure that the separation of the business results in a very healthy, sustainable business that will be able to service customers in a very robust way and be able to serve its owners in a very robust way. And that commitment really leads us to the view that this business will do best as an integrated enterprise, so that's really the way that we're thinking about it. Joseph Nadol - JP Morgan Chase & Co: Secondly on this, there's been some customer, was it obviously political things kind of circulating around out there since the announcement, including from Secretary of the Navy. And just wondering if you have any reaction to some of the push-back and any thoughts you might have?

I would only say that broadly, the customer base is waiting to see how we take the next steps forward. They're going to want to make sure that we're doing the right things for the future of this business, and we're committed to doing the right things for the future of the business. So I would expect to see a variety of commentary floating around as this process ensues, but we have committed to the Navy to working closely with them as we go through this, and I see us on a good track to make sure we get the right outcome, Joe. Joseph Nadol - JP Morgan Chase & Co: How inexplicably linked are these two separate moves, which are shutting Avondale and divesting the business in some way? If politically, it becomes impossible to shut Avondale for whatever reason, is the spin or the sale still going to happen because it would seem to me that you're probably selling them together to the Navy, saying, look we're saving you money in total, but if you can't shut Avondale, the cost to the Navy is going to go up because of the additional overhead you're going to be putting on a separate business. So how linked are these two moves?

Joe, let me just touch on Avondale for just a moment. We have made a business decision. We are proceeding with that business decision. And from a looking-forward perspective, we believe that, that business decision is the right thing for the customer and is the right thing for the overall business, for the sustainability of that business for the long term. As I said in the call we had a couple of weeks ago, when we think about Gulf Coast shipbuilding, we think it's important to the nation that we have a strong Gulf Coast shipbuilding capability, and to achieve that outcome, we need to consolidate. So we are marching forward in that direction, and I know that, that's difficult from a lot of different perspectives. It was a difficult decision, but we believe strongly it is the right decision that we're moving forward. We see that as a decision focused around the business, what's the right thing to do for the business. The separation decision is a decision focused around the strategy of the company and how we create best value with the two pieces going forward for our shareholders. And we also are focused on driving that to the right conclusions as we explore these alternatives. So I'd be careful about overly linking these things. We see them as two decisions, both of which are, we believe the absolute right decisions for the future of the business.

Your next question comes from the line of George Shapiro of Access 342.

Two questions, one for Jim. The 11% guidance in Aerospace for the second half of the year, I mean, implies it's got to go down to 10.6%, and even the first quarter was 11% and there weren't any program adjustments then. So some upward program adjustments continuing, I mean, with at least the higher margin continuing in the second half of the year on some of the programs and NPOESS is probably only about $250 million or even less in revenues for the second half. It just seems like that guidance is conservative unless there's something unique going on in the second half.

I'd say, George, your math is spot on first of all. Second of all, there's always program adjustments in every quarter, and what I said is the rate or the volume of program adjustments in the second quarter were greater than what we have seen in the past. And so I can't really forecast if that is going to continue going forward, so that's essentially how we get to the 11% rate for the year.

But I mean in the first quarter you had 11% margin, and you didn't highlight program adjustments. And for the second half, you got to get lower than that. You got to get to 10.6%, obviously, to meet your guidance.

Those guys in the Aerospace sector have been just hitting the ball out of the park this year. And yes, I guess I could agree with you. There's a chance that we're going to do better than our 11% guidance, but if I'd look at it today, frankly, they look at it today, they'll think 11% is where we're going to end the year, but yes, you might be right. There could be upward pressure here.

And then just one more in general for you, Wes, I mean, with Carter talking of saving out time-and-material contracts, I mean, you'd see that having much of an impact in your IS business?

It depends on where that type of contracting goes. If it migrates primarily to cost plus, then you could have a little bit of a downward pressure on the profitability just because of the differential rates that you sometimes see. Some of that business could migrate fix priced though. And so we kind of have to wait and see what happens to it.

You have roughly what percentage of your businesses is time and material now?

I don't think we've disclosed that publicly.

No, we have not.

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

So how much of your move to D.C., how much of the cost of the move do you expect to be allowable and therefore covered by the government? How much might the savings be and how much of that would you have to give back to the government? And on a broader basis, Lockheed kind of went forward with its voluntary separation plan. You've already done quite a lot to sort of take out layers of management. Do you see additional opportunity to do that? And would that accrue to Northrop or does that all go through the Department of Defense?

Let see, Cai. Some of the move costs will be allowable, others will be unallowable. We hadn't gotten into the details publicly. I don't really think it's something that I'd need to do at this point. It's important, but I don't think it's going to be a major driver here and any of our operations on a go-forward basis, nor have we talked about the savings, so I'd just rather leave that alone at this point in time.

But just from 20,000 feet, I guess the issue is kind of looking at your businesses of businesses, if you take cost out, I mean, obviously, if it's cost plus, your share goes to the government, but if it's fixed priced, maybe you keep some of it. But is the environment changing to the point where the quid pro quo is, guys, you have to take cost out and we need it all. So I think I...

I wouldn't say the environment's changing, Cai. You're right that on a cost-type contract, the government shares in the cost. On a fixed-price contract, we keep the cost savings, but when you negotiate the next year's contract, you give it back. So essentially, the name of the game here is all about affordability. That's driving your cost down so you can really be competitive and win the new opportunities when they arise.

And then the last one, maybe this is for Wes. You've done a lot already in terms of cutting costs and consolidating. Do you see further opportunity to take out layers of management?

Cai, I would say yes, you're right, we have done a lot. In the consolidation of the sectors, we have reduced the management of the company substantially in that process. In terms of where we go as we move forward, we see continuing opportunities to address it, the degree to which those opportunities reside in management layers versus other cost synergies. I don't think I want to go into in great detail publicly, but we do see continuing opportunities to address cost. It's part of what we're working on as we think about the affordability perspective in a broad sense. And to some extent, as I said in response to an earlier question, it depends a little bit on how the customer's going to approach this. Oftentimes, organizational structure has to mirror the customer to some extent, support all of the compliance functions that you engage in as we work to make sure that we are doing all the things that our customers expect. As those expectations could be modulated going forward, that might provide some opportunity as well.

And Wes, you want to make a few comments and...

Yes, I would just say in summary, we had another solid quarter in terms of performance. We are continuing to proactively manage our business to create value for our shoulders, our customers and our employees. I think you can see that our results this quarter reflect our focus on improving our performance, and just to reiterate what I've said a number of times before, our number one priority across all of our businesses, our entire organization is going to continue to be to achieve sustainable performance improvement. So thanks for your interest in our company. We appreciate you joining us on our call today.

Thank you for joining today's conference. This concludes the presentation. You may now disconnect. Good day.