Northrop Grumman Corporation (NOC) Q1 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Northrop Grumman First Quarter Earnings Conference Call. My name is Dienna, and I'll be the operator for today. [Operator Instructions] As a reminder, today's conference is being recorded for replay purposes. I would now like to turn the call over to your host, Mr. Steve Movius, Vice President, Investor Relations. Please proceed.

Thanks, Dienna, and welcome to Northrop Grumman's first quarter 2012 conference call. We provided supplemental information in the form of a PowerPoint presentation, which you can access at www.northropgrumman.com. Before we start, please understand that matters discussed on today's call constitute forward-looking statements pursuant to Safe Harbor provisions of federal securities laws. Forward-looking statements involve risks and uncertainties, which are detailed in today's press release and our SEC filings. These risk factors may cause actual company results to differ materially. On the call today are our Chairman and CEO, Wes Bush; and our CFO, Jim Palmer. At this time, please go to Slide 3. And I'd like to turn the call over to Wes.

All right. Thanks, Steve. Good morning, everyone. Things for joining us. We're very pleased with this quarter's results. We're off to a strong start for the year in a challenging environment. It's rewarding to see the positive results being generated by our team's continued focus on performance, affordability and efficiency. As we've mentioned on our last few calls, we've been working hard across the company to reduce costs and improve productivity, and those efforts are continuing to pay off in terms of our financial results and our performance for our customers. First quarter earnings per share from continuing operations rose 17% to $1.96, and on a pension-adjusted basis, earnings per share rose 31%. EPS growth for the quarter reflects improved performance across all 4 of our businesses as well as the positive impact of our share repurchases. Despite lower sales, 3 of our 4 businesses posted higher operating income and all 4 sectors generated higher margin rates. Electronic Systems and Information Systems had particularly strong quarters. As a result, our segment operating income increased 9% and our segment margin rate increased 200 basis points to 12.7%. During the quarter, we repurchased 4.4 million shares of our common stock for approximately $260 million. We plan to continue executing a balanced cash deployment strategy that includes returning cash to shareholders through share repurchases and dividends. Historically, our return of cash to shareholders has been weighted towards share repurchases, and we don't have any plans to change our practice. Our 2012 EPS guidance assumes a reduction in weighted average shares outstanding of approximately 9%. We consider our dividend a long-term commitment to shareholders, and we evaluate our dividend as a payout ratio of pension-adjusted earnings. Maintaining a competitive dividend payout in line with our industry continues to be our focus. Now I'll provide a top level of our first quarter performance, and then Jim will provide some additional details. First quarter sales of $6.2 billion are consistent with our expectations and support our guidance for the year. Our sales outlook assumes a continuing resolution of the fourth quarter, but does not contemplate extraordinary customer actions in anticipation of potential sequestration. As we discussed last quarter in providing a 2012 guidance, our portfolio-shaping actions and the adoption of units of delivery revenue recognition on F-35 LRIP 5 will reduce year-over-year sales by approximately $500 million; and changes to a number of our programs, including fewer F/A-18 deliveries as we transition from multiyear 2 to multiyear 3; cancellation of NPOESS DWSS; lower volume for B-2 and Joint STARS modernization programs; lower in-theater sales; and lower ICBM volume will have an aggregate impact of approximately $1 billion on 2012 sales. Together, these factors reduced our first quarter sales by approximately $450 million with F-35 representing about $90 million of that impact. We expect sales to be more heavily weighted toward the second half of the year, as F-35 LRIP 5 deliveries are expected to begin in the third quarter. New business awards in the quarter totaled $5.8 billion, a book-to-bill ratio of 94%. We ended the quarter with total backlog of $39.1 billion, down slightly from year end, but a satisfactory result given program award delays. Notable follow-on awards for AS include $919 million for the E-2D Advanced Hawkeye and $289 million for the F-35. ES received an $88 million FMS award for F-16 fire control radars for several foreign countries and was also awarded $332 million for LAIRCM. TS received $100 million contract to continue supporting the Army's 3-core Mission Command Training Center. Information Systems was awarded $122 million follow-on award for Counter-Rocket, Artillery and Mortar systems. Over the last 2 quarters, IS also has won several important competitions. These include CANES, a program to consolidate and modernize the U.S. Navy shipboard network systems to improve operational effectiveness and affordability across the fleet, the ground combat vehicle C4ISR suite and the Air and Space Operations Center Weapons Systems Modernization Program, called AOC WS. AOC WS is the Air Force's command and control center for planning, executing and assessing joint air operations during a contingency or conflict. These captures, along with the ground missile defense team award, represent future potential awards and revenue in the billions of dollars for Information Systems. They also demonstrate that our C4ISR domain knowledge, coupled with SBIR, is a growing, competitive discriminator. These wins demonstrate our ability to apply our deep domain knowledge and differentiating technologies in innovative ways to produce affordable, lower-cost solutions that address multiple threats or have a multiplier effect on mission capability. In today's budget environment, our customers are leaning away from expensive, exquisite solutions. They are generally seeking the lowest-cost, technically acceptable solutions and our ability to innovate, in combination with our discriminating technology and competitive cost structure, has provided a real competitive advantage. Based on the strength of this quarter's results, we are raising our 2012 EPS guidance to a range of $6.70 to $6.95. Higher 2012 EPS guidance principally reflects this quarter's exceptional operating performance and is supported by an increase in our expected segment operating margin rate to the mid-11% level. I would reiterate that we remain focused on positioning the company for an increasingly competitive and challenging environment. Deficit reduction is a critical national priority. We expect a significant amount of debate and dialogue regarding how the defense budgets will be impacted by deficit-reduction actions. While the outcome of that debate remains uncertain, we are formulating contingency plans for the possibility of sequestration occurring in January 2013. I want to be clear that the implementation of sequestration, as presently mandated, could have a very serious negative impact on our company, our industry, and of course, on the defense capacity of our nation. In this environment, our challenge is to continue to anticipate our customers' needs, aggressively address our cost structure and continue to improve our operational execution and affordability. We continue to take actions across the company to improve our competitive position. And while customer spending is being impacted by budget uncertainty, we continue to see demand in our core integrated C4ISR, Unmanned Systems, Cybersecurity and logistics markets. We believe these capabilities will continue to be vital to global and national security. We also believe that we can continue to create value for our shareholders even in an environment of constrained top line growth by focusing on our key priorities: driving performance, deploying cash effectively and optimizing our portfolio. This quarter's results continue to demonstrate the success of that strategy. So now I'll turn the call over to Jim for a more detailed discussion of our results and guidance. Jim?

Thanks, Wes, and good morning, ladies and gentlemen. I'll provide a little bit more detail on our first quarter results, which obviously are a great start to the year. The highlights for the quarter were the 12.7% segment operating margin rate, which combined with our share repurchases, generated a 31% increase in pension-adjusted earnings per share, an outstanding quarter. Strong operating performance more than offset the impact of lower sales, a lower net FAS/CAS pension adjustment and higher corporate unallocated expenses. On an absolute basis, even with $71 million lower net FAS/CAS pension adjustment, total operating income was roughly comparable to last year, and the operating margin rate increased 80 basis points to 12.8%. Pension-adjusted operating margin increased 8% and pension-adjusted operating margin rate increased 180 basis points to 12.3%. For the quarter, we had a lower tax rate due to higher manufacturing deductions and somewhat higher other income, reflecting positive first quarter returns on assets related to some of our nonqualified benefit plans. And finally, weighted average shares outstanding are 13% lower due to our share repurchases. Cash results for the quarter were as expected and reflect higher working capital and higher income tax payments. And as we said last quarter, we expect cash to be heavily weighted towards the second half of the year as is our typical pattern. We are maintaining our guidance of $2.3 billion to $2.6 billion of cash from operations and $1.8 billion to $2.1 billion of free cash flow for the year. Turning to the sectors. Aerospace Systems. Sales declined $210 million or 8% while operating income declined 3% due to the lower volume, and operating margin rate expanded 60 basis points due to improved performance. Adoption of the units of delivery revenue recognition for F-35 LRIP 5 impacted sales in the quarter by approximately $90 million and the NPOESS cancellation impacted quarterly sales by about $40 million. F-18 volume was lower due to 3 fewer deliveries than in the prior year. And B-2 and Joint STARS volume declined as modernization efforts on those platforms tapered off slightly. Lower volume for these programs were more than offset by higher sales for the E-2D and our unmanned programs. For the year, we continue to expect AS sales in the range of $9.7 billion to $10 billion and based on first quarter performance, we are now expecting a mid-11% margin rate for AS, an increase from our prior guidance of low to mid-11%. AS 2012 will be somewhat back end loaded due to timing of F-35 LRIP 5 deliveries. For the entire company, F-35 sales in 2012 will be about $1 billion. That amount includes F-35 volume for AS, IS and ES, with most of the sales being recognized at AS. Our guidance assumes about 1/3 of those sales will be recognized in the first half of the year and the balance, or 2/3, in the second half of the year. Electronic Systems saw sales decline by $84 million or 5%, primarily due to a $90 million decline in post-automation volume, largely reflecting the final delivery of systems under the Flats Sequencing Systems contract with the U.S. Postal Service and our decision to deemphasize the domestic postal automation business going forward. Despite lower sales, ES operating income increased $67 million or 28%, and their margin rate for the quarter was 17.6%. ES recognized a higher level of favorable adjustments on their contracts for the mitigation of contract risk, including adjustments for contracts completing or nearing completion than in the prior year. While none of these adjustments were material on an individual contract basis, in total they increased first quarter operating income by about $60 million. The quarter's results also reflect risk-mitigation and cost-reduction actions that favorably impacted fixed price contracts, which are a substantial portion of ES business. While we expect the positive impact of our contract risk management process and cost-reduction and affordability initiatives to continue, we don't expect a repeat of this quarter's unusually high level of positive contract adjustments at ES. For the year, we continue to expect ES revenue of $6.9 billion to $7.2 billion, and we are increasing our margin rate guidance from the mid to high 13% range to the mid-14% range. This guidance reflects a margin rate in the mid-13% for the balance of the year. Information Systems had sales decline of $181 million or 9%. The sale of San Diego contract, cancellation of JTRS AMF and in-theater drawdowns impacted sales by about $100 million with the balance of the decline reflecting general market softening due to the uncertainty of the budget environment and the shorter cycle nature of our IS business. Operating income at IS increased 6%, and margin rate expanded 150 basis points to 11.1%. Favorable performance on several civil systems programs, as well as cost reductions from affordability initiatives, more than offset the impact of the lower volume. For the year, we continue to expect sales of $7.4 billion to $7.6 billion for the IS business with an operating margin rate in the mid-9% range. I should also note that last week, we sold the Park Air Norway business, a business that is focused on civil air traffic management and that divestiture will impact IS 2012 sales by about $50 million, obviously contemplated in our guidance for the year. But also note that IS had a 3% increase in backlog with new business awards during the quarter representing 115% book-to-bill ratio. Finally, for Technical Services, first quarter sales declined $81 million or 10%. The deemphasis of some of our base and range operations and lower ICBM volume impacted sales by about $50 million and the KC-10 volume was about $25 million lower than last year. Operating margin rate expanded 110 basis points to 9.3% due to the improved performance for several programs, including the KC-10 program. For the year, we continue to expect TS sales at $2.6 billion to $2.7 billion, probably closer to the high end of $2.7 billion with a mid-8% operating margin rate. So on a consolidated basis, our 2012 sales guidance remains at $24.7 billion to $25.4 billion. And based on the first quarter performance, we are increasing our segment operating margin rate guidance to mid-11% from approximately 11% previously. Total operating margin rate guidance has increased to the low 11% range from mid- to high 10%. As we will disclose in our 10-Q filing later today, first quarter net cume catch-up adjustments were $121 million greater than in the prior year period. The improvement results from our risk management process and affordability initiatives across the company. Individually, none of the contract adjustments were material. Our 2012 EPS guidance assumes $130 million of net FAS/CAS pension income, a tax rate of approximately 33.75% compared with our prior assumption of 34.25%, reflecting the higher level of manufacturing deductions in the first quarter, but not assuming an extension of the R&D tax credit. So now, with 2012 guidance out of the way, let me spend a few minutes and talk about a subject that I think is near and dear to many of you, 2013 pension expense and the resulting net FAS/CAS pension adjustment for that year and then some of the key assumptions or sensitivities on those amounts. Holding the discount rate constant and assuming we achieve the expected long-term rate of return on our plan assets, our estimated 2013 net FAS pension adjustment would be income of about $250 million. It reflects about $590 million of CAS expense, obviously the difference being FAS expense. And of course, actual results will likely vary and we can't really predict what's going to happen with discount rates, which is, as you know, one of the key variables. So talking about some of those sensitivities. A 25 basis point change in the discount rate would have an impact of about $75 million on 2013 costs whereas 100 basis point variation around our long-term expected rate of return, which is 8.25%, has an impact of about $40 million. And I should point out at the end of the first quarter, our return on our pension plan assets was in the 5% range. And finally, I want to spend a few minutes on cash. In the 10-K, we disclosed an estimated 2013 mandatory cash contribution of about $300 million. I should point out that this estimate is based on many assumptions, including the PPA interest rates in effect at that point at the beginning of the year. I think some of you may know that those rates change every month, so the actual amount will, in all likelihood, be different than that estimate. So let me just conclude my comments by saying that the first quarter results demonstrated just outstanding operational performance. As Wes said, we remain focused on generating shareholder value through performance improvement, effective cash deployment and portfolio optimization. And Steve, with that, I think we're ready for some questions.

Thanks, Jim. [Operator Instructions] So Dienna, at this time, we are ready to begin the Q&A process.

[Operator Instructions] And the first question comes from the line of Joe Nadol, JPMorgan. Joseph Nadol - JP Morgan Chase & Co, Research Division: Jim, thanks for the expanded commentary this quarter. My question is on the Electronic segment where you had those great margins, and I heard in your comments -- your intro comments. Just wondering if you could -- if we could dive in there a little bit and if you give us maybe a sense of, at this point, the sales mix there from an international versus domestic standpoint, fixed price versus cost plus and I guess I don't know if there's a way to quantify the maturity level of those. Maybe give us a sense as to whether this kind of performance can recur.

Joe, I don't think there's any change in this quarter in the overall mix of the business or the international versus domestic content of the business. As I said in my comments, we continue to work really hard on our risk management process and affordability initiatives, the roughly $60 million of cume catch-up adjustments that I've highlighted in my comments were spread across a number of contracts, about15 contracts, none of which were individually significant. So I just -- it's just real good blocking and tackling and managing the business.

And Joe, I would add if you look at our projection for the year for Electronics, it basically suggests that the remainder of the year will be operating closer to the rates that Jim has talked about extensively in the past. Joseph Nadol - JP Morgan Chase & Co, Research Division: And then for my follow-up, Wes, you mentioned in your intro comments, in the environment and sequestration, I was wondering if you could maybe expand on that a little bit. Specifically, it sounds like DoD is going to have to start planning for sequestration this summer or at least early fall. Doesn't sound like the political process is going to enable a solution to this, if we get one, until after the election in November. So what are you doing, more specifically, to prepare for this? And how are you thinking about this with your guidance and the fact that the sales profile is pretty evenly spread, even picking up a little bit towards the end of the year?

Well, as I said, our guidance does not anticipate that our customer community would take any extraordinary actions at the end of the year. Should they do so, obviously, that could be an impact to us and everybody in our industry. I think, to put this in a broader context, my sense of the situation is those on the Hill that are putting some time and energy into this are thinking about it very responsibly. They recognize that allowing sequestration to occur would simply have a devastating impact on the ability of the Department of Defense and other government agencies to support the security of our country. And it would have clearly a very negative impact on the defense industrial base. And so, there is a lot of discussion, a lot of debate around how to deal with this ugly situation now. Despite all of those good intentions, as you point out, we are in election year, and I think the general view is it's going to be hard to see something meaningful happen in advance of the election. So calling it now on exactly how that's going to come out is difficult, and because it's difficult to call it, everyone that's on the receiving end of this, including our customer community and ourselves, are sort of forced into the situation of having to plan contingency plans for the possibility of this very terrible thing actually happening. So that's what we're doing from our side of the equation here in our company. We're thinking through, if this would actually get triggered, how would we respond. And that has a number of dimensions. It has a number of dimensions on the contractual side and it certainly has a number of dimensions on all of the components of the operations within our company. So it's not just a broad brush. It's work our way through it step at a time. And I think part of the challenge, and I'm sure you've heard others in our industry speak on this, that probably no one in government can be prepared for if sequestration is actually implemented as is currently mandated, the department will have actually little discretion on many things that it has to do with respect to the line item budgets. Translating that into contract actions is going to be very, very difficult and the response that industry will have to provide on those contract actions will, I think, throw the department into great turmoil and result in bills being sent in for actions on contracts that no one has planned for. So this whole idea that this was supposed to be a so terrible of an outcome that would force Congress to not go there, I hope that turns out to be the case because the consequences are very substantial. But we are, as I'm sure others in our industry are doing, getting ready so that we can respond to that effectively, do it in a way that hopefully helps our customers work their way through it, but also protects the integrity as much as we can in that situation, the integrity of our ability to perform our mission. It's a fairly comprehensive process.

And the next question comes from the line of Doug Harned, Sanford Bernstein. Douglas S. Harned - Sanford C. Bernstein & Co., LLC., Research Division: You had several cancellations in the 2013 budget and some delays, strictly in the Aerospace side. But when I look at your results now, you're maintaining guidance there. Backlog looks reasonably good. Have you -- were you surprised by some things that some things would they have led you to lower your outlook a little bit either this year or I'd say next year?

Doug, it's Wes. I would say that going into the year, as we were formulating our guidance, we do what I think you should expect of us, which is to look at the whole array of possible outcomes from a budgeting perspective and really think our way through that in our guidance. And so I think if you look at how the outcomes are abounded and once we actually did see the President's budget, it fit pretty well within the range that we expected. So we don't like all of those outcomes, of course, and as you know, there are many of them that we are working very diligently with our broad customer community to address. But so far, I think what we're seeing works with the guidance that we gave. Douglas S. Harned - Sanford C. Bernstein & Co., LLC., Research Division: And then within Aerospace, if you look at unmanned, as we exit Afghanistan -- there'll be changes to unmanned missions. We've seen some -- also changes in the -- even the decision to go with the U-2 instead of Global Hawk based on costs. It looks like there are changes in the requirements of how they're thinking about them for the Navy UCLASS competition. Are you -- how are you looking at unmanned right now as a whole portfolio? I mean I think of you as the leaders in this space, but are you watching -- are you seeing shifts in it and the need to change anything about your strategy in that area?

Doug, I would say when we look at the military strategy that the Department of Defense, and in fact the President went over to DoD and himself introduced the new military strategy at the beginning of the year, when you go through that very carefully, it's clear that the range of missions that will be the priorities as we go forward and Asia Pacific gets a lot of attention in that regard and deservedly so, but if you look at the full range of missions, that the need for unmanned capability from our perspective is going to continue to grow. It is clearly the wave of the future. We'll go through some bumps of implementation and acceptance, if you will, in terms of which missions get translated over to unmanned on what time line. But I don't think there's anything that, actually over time, will hold that back. It is clearly the most efficient, and I would say cost-efficient as well, to address one of the points you made before, ways of doing a mission. It represents a much more manageable risk profile for the country. And just from a pure technological superiority perspective, with respect to our long-term defense aspirations as a nation, unmanned is the right answer. So we continue to see this as a very robust business. We continue to invest in it to ensure that we maintain our strength in this marketplace. And we really like the breadth of our portfolio, ranging from some very small little unmanned vehicles that we produce up through the rotary-wing capabilities to medium class and all the way up to the full scale Global Hawk and then BAMS. And when you look at even the ongoing discussions around the Global Hawk platform and its derivative on the Navy side, the strength of the commitment, particularly by the Navy BAMS, I think, reinforces our perspective.

And the next question comes from the line of Howard Rubel, Jefferies & Company. Howard A. Rubel - Jefferies & Company, Inc., Research Division: I have 2 questions. First, Wes -- maybe they're related. First, Wes, could you talk about how -- when we look at the proxy, what we find is that your -- the named executive officers have a market-adjusted compensation basis and it sure seems as if it's impacting some of the decisions. Could you sort of -- that you're taking with respect to portfolio optimization and so on, could you take a moment to talk about that?

Howard, I want to make sure I answer the question you have, and I'm not sure I understood it. The market-adjusted basis for? Howard A. Rubel - Jefferies & Company, Inc., Research Division: As I read the proxy, as I understand it, in addition to just merely meeting the goals that the board asks of you or the guidance, in addition to that, your -- there's an overlay that I think adjusts some the named executives officers' compensation to market returns of the entire group. So you have to not only make your numbers, you have to beat your peers. Could you talk about that in a context of portfolio optimization and other actions you've taken?

Okay, I get it. I think that's kind of 2 perspectives. One is as we set the annual goals for our performance, we do market benchmarking on those. And I think you've heard me describe before as we have been focusing on our performance within our company, we don't want to just be grading ourselves against ourselves in terms of performance improvement against where we've been. We really want to be measuring ourselves against the marketplace, which is what, of course, all of those who are thinking about holding our shares are doing. And so that is something we go through on an annual basis. We look very carefully at market performance and we set our targets on that basis. This has been a little bit of a change, and most companies or many companies set their annual targets based on their plan. And that is, I'm sure, a very good discipline in many respects. For us, it was my view and the view of the board, and quite frankly, the view of our leadership team that, that wasn't just the way we wanted to look at it. We really wanted to hold ourselves accountable to perhaps a little bit higher standard. So on an annual basis, we take a hard look at each of the metrics, both our financial and our nonfinancial metrics as well. We do a lot of benchmarking to make sure we have a good sense of where we are and where we want to go and we drive our metrics on that basis. The other piece of this is also on a long-term basis and you may also be referring to that. Our performance shares, that are the grants to our officers and our company, have a component to them that is measured on TSR. And of course, that's a relative measure against a couple of different benchmarks that we have in the industry. So the whole idea here is if we're committed to improving, it needs to be improving relative to how the marketplace is doing. Howard A. Rubel - Jefferies & Company, Inc., Research Division: Yes, I get it. That sort of talks to it. And then just in terms of can you maybe cite an example or 2 of -- I mean obviously maybe the tanker a year ago is deciding that you didn't want 0 margin businesses as part of the portfolio was one example, but can you cite something today or a couple of instances today where that's the goal -- the objective is being translated into action.

Well, yes. I think it drives thinking across the whole array of decisions that we make as a leadership team. Clearly, we've been doing a lot of work on portfolio shaping across our portfolio. Some of that has been, I would say, more strategic in nature with respect to what actually fits and where there's real synergy. But some of it has been around what businesses do we really want to be in if we're not able to get the returns out of them, that we expect of the investments we make and obviously we think our shareholders should expect. So whether it's our decisions to whether to bid or not bid on a particular contract or our decision as to whether we want to be in a business or not be in a business, we're -- quite frankly, when we're looking at making our asset investments internally, we have that same mindset as well in that regard. So it's comprehensive. As everyone knows, when you create a way of measuring within a company, you're basically deciding what it is you value. And people respond to that, good people respond to that, and I'm proud of our team.

The next question comes from the line of Cai Von Rumohr, Cowen and Company.

Yes, it's about your dividend. Your GAAP -- your pension-adjusted earnings based on your guidance look relatively level this year. Your dividend currently is $2 and I guess normally you'd review it at the middle of next month. So can you give us a little bit more color in terms of should we assume therefore the dividend doesn't increase? Or maybe give us a little bit more color in terms of how you think of your dividend in light of your overall cash deployment?

Well, Cai, as I mentioned in my remarks, dividend is very, very important to us. We do treat it as a long-term commitment to our shareholders and we think about it very carefully. And your right in with respect to our timing, we normally go through this kind of in the May time frame. I don't want to be in a position of getting ahead of that discussion that we're going to have. That's a discussion that's not complete within the company yet, certainly not with the board and we're going to go through that when we get together. But as I said in my remarks, we do like the relative weighting towards share repurchase that we've had in the past. I think that has served us well. And our guidance this year contemplates a reduction in shares outstanding, about 9%. So -- and that's all sort of to give you a little bit of illumination in our thinking. But as a company, we, I think, established a good, solid track record of looking at our dividend each year and having some movement in our dividend. So as I said, I don't want to get ahead of the discussion, but that's kind of a reflection of our history and our thinking.

Okay, and then one for Jim. You've mentioned the $300 million in potential required pension contributions next year. What does that imply regarding CAS harmonization and/or the transportation funding bill that would basically relax ERISA funding requirements?

As I said, first of all, CAS harmonization has nothing to do with funding. How much we have to fund in their plan it's all based on the PPA rates. If we -- and I'm aware of, of potential for a relaxation around those rates, I would expect that if we do see legislation to relax, that would move towards a longer-term view of those rates rather than essentially what is a average over the last 24 months in the current PPA legislation or rules. So all of that should result, assuming we get that relaxation, in a lower required contribution in 2013.

Our next question comes from the line of Robert Spingarn, Credit Suisse. Robert Spingarn - Crédit Suisse AG, Research Division: Wes, just going back to the dividend and understanding what you just said, which is that that's an upcoming discussion and you don't want to get too far ahead of that. But when you talk about the ratio, and I look at the historical increases that are I think in the mid- to high single digits in terms of percent terms over the last 3 or 4 years, that leaves you a little bit below the peer leaders in the group. And I wondered if you could comment within -- in that context where you'd like to be relative to those guys or if it's better to be just at the average of the overall group, which is about where you are.

Well, it's part of the discussion that we go through each year. And I said, you can kind of look back at our history and see where that's come out in the past. But I really -- I think I've said all I have to say on that one given that we're kind of in the middle of thinking our way through it. So we'll have more to say, obviously, once we get to a decision on it. Robert Spingarn - Crédit Suisse AG, Research Division: Fair enough, fair enough. Obviously, it's an important topic here for everybody. Jim, a question for you. You mentioned that the adjustments in Electronic Systems, and I suppose perhaps this is elsewhere, were they were numerous and they were fairly small. I think you said 15 in Electronic Systems. But how could we quantify the largest of those, either there or perhaps in one of the other segments. Were there any that were approaching perhaps the $10 million level?

Rob, again, as I said, none of them were, in my view, material. I mentioned the $60 million that was made up of about 15 contracts. Frankly, if we look at the whole cume catch-up adjustment process, there's probably hundreds, maybe even thousand contracts, that are adjusted every quarter. So I stand by my comments. I just don't think that any of them were individually significant and the team has been real disciplined in the management process, the risk management process. And don't lose sight of the importance of the affordability initiatives that we have undertaken that has an impact on our forward margin overhead rates, which are important element of the operating performance in each individual contract. It is really essentially doing what you are supposed to do in managing your business. Robert Spingarn - Crédit Suisse AG, Research Division: Well, maybe this leads to a larger question, either for you or for Wes, which is this trend seems to have really taken on some momentum for Northrop and for others in that there's more margin here than there was before and maybe it's the specter of what's coming down the pike from a top line perspective. But perhaps you can comment on what it is that is enabling you and others to improve profitability at such a level today relative to a few years back.

I'm going to go back to Wes' answer to Howard's comments. We have really focused our team around managing the business, being prudent managers of the risk in the business and driving the organization, incentivizing the compensation of the organization to be well aligned with those management objectives. And we have the hearts and minds of the team. And we're really working hard on that overall risk management process and it's a difficult environment. It's getting increasingly difficult as we go through the last couple of years. But our team has really responded well. Robert Spingarn - Crédit Suisse AG, Research Division: Wes, do you have any comment on how long you can drive this process? Do you run out of headroom?

Well, I would also reflect back on our discussions on sustainable margin rates. When we look at the future, and quite frankly that's informed by the past as well, broadly across industry, we talked a lot about the sustainable rates that we expect that we can be achieving in each of our businesses. We've not changed any of those perspectives in our discussions. And as we go through the process of managing the risk out of individual programs, we will find places and opportunities where we see these nice opportunities to recognize that risk mitigation. One of our biggest activities in our company that's underway for a number of years was to really drive an increased level of discipline in the decisions we make getting into the contracts. And so, as we're able to trim out of our portfolio, either through managing the risk out of it or actually deciding not to take on some contracts that don't have as good a return opportunity, that clearly has helped us. And if you look back over the last 3 or 4 years, that's helped us a lot in terms of our performance level. But if your question is really more forward-looking, I think the descriptions that we've used around the sustainable margin rates that are sort of inherent in the businesses, assuming that we're operating them effectively, it's a good way of thinking about our company.

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

As you get closer to the end of the year and the potential for sequestration, Wes, you talked about some of the contingencies. But I'm curious intra- year, are we going to start to see behavioral shifts at you and the industry to kind of protect yourself? And what kind of moves, whether that's capital preservation or just general behavior would we likely see manifest?

I think what you're going to see first and foremost from our industry and certainly from our company is an absolute commitment to support our customers full throttle, and we're doing that. We take on contracts and those are commitments that we make. So we will not do anything that will impair our ability to support our customers and execute those contracts with every ounce of efficiency and focus on meeting our commitments that we can possibly bring to the table. And that's what our customers are doing, too, I would say. If you look at how the department is operating today, even with this ugly cloud that's out there on the horizon, the department has not backed off from conducting its mission around the globe. And I think we all have to admire that behavior on the part of the Department of Defense and the other government agencies that are having to operate with this uncertainty hanging over their heads. So we're all going to be going through what I'll describe as a planning process and a contingency process so that we are ready to take action, we're not having to figure out should it actually occur. But in a broad sense, I think it would be irresponsible of us to take actions that would somehow slow down or impair the ability of our company to meet our commitments. So that's the way we're thinking about it.

And I guess to tie it back to the dividend discussion, does it any way hang over that discussion as well or do you see it as more of an isolated risk rather than part of the ongoing capital deployment strategy?

It's not really been a significant part of our thinking around dividend. Our dividend thinking has been more shaped by the parameters that I described a little bit earlier. The dividend, when you look at dividend as a total part of our cash deployment, it's not the live-or-die part of our cash deployment.

The only other one, Jim, clarification, I guess, on the positive adjustments year-to-date. What's baked into the full year guidance on a year-on-year basis at this point?

Myles, I tend to think about it in terms of the overall margin rates for each of the sectors than the company, as opposed to x amount of cume catch-up adjustments. And frankly, cume catch-up adjustments is one of the factors in the margin rates, but it is not the only factor. It is the resulting margin rate that we recognize on a go-forward basis after those adjustments as well. So I don't think you can put a number on that. It's more important to look at the overall margin rate of the business.

Okay. So I guess another way of asking it, the implied back half margins or the last 3 quarter margins of 11% versus 11.9% last year, can you -- is that largely cume catches or mix or something else?

Really a reflection of where we think the business is going to be, our forecast for this year.

The next question comes from the line of Jason Gursky, Citi.

Two questions. Going back to the margins. Clearly, you've been successful in operating above what you've described as sustainable margin rate. So that begs the question do you -- your target margins perhaps represent the floor for you as you think about margins, or could we see periods of time where you are below that for a small period of time and above it for other periods of time? I'm just trying to get -- I think we're all curious as to how long you can outperform, so to speak, relative to your own targets or maybe those targets aren't really where you think you're going to be but rather a floor.

I tend to frankly think about those as targets through the cycle of the business. We do, as Wes mentioned earlier, spend a lot of time looking at our historical performance, our competitors' performance, our peers' performance. You can look at our performance in the past and some of our peers. We've been below and above those long-term sustainable targets. But again, given my background experience, looking across the industry at our major peers, I think they represent, as I said, sustainable margin rates through the cycle. There are times when individual organizations who have margin rates better than those and worse than those. Clearly, we have -- we're incentivized to try to drive our organization to perform as best that we can. We're being very conscious about the actions we take to manage our costs; to improve the affordability of our products; to manage the risk in our contracts; to make good, prudent contract decisions upfront. My experience tells me it's very difficult to overcome a bad contract. So we make, as Wes mentioned, earlier very prudent decisions about contract terms and conditions and estimates of costs when we enter into those contracts. So it's just the whole management process around the nature of our business.

Okay, that's great. And then just as the follow-up question. Can you give us a bit of an update on both the Global Hawk and the Fire Scout programs, where we are with Block 40 and just overall kind of demand in program development milestones on both those programs?

Yes, Jason, let me give you a quick update. Global Hawk, sort of broadly across the blocks of Global Hawk, all right, is continuing to provide absolutely superior mission performance around the globe. And as I mentioned in one of my earlier remarks, as we see an increasing focus in Asia Pacific, the notion of unmanned systems with long duration and extraordinary time on station really, really makes a lot of sense and we can see it in terms of the eagerness with which the men around the globe are utilizing the Global Hawks they have today and looking forward to the Global Hawks that they see coming down the line. With respect to the Block 30 issue that was illuminated in an earlier question, we are continuing to execute the contracts on Global Hawk Block 30, continuing to demonstrate strong contract performance. And we are working closely with the Air Force to sort out the path forward for that particular segment of the overall Global Hawk enterprise. I think you also asked about the Fire Scout. Fire Scout continues to, overall as a program, do very well with accumulated greater than, I think, it's 5,000 flight hours at this point and more than 3,000 of those are on operational deployment. There were 2 incidents over the past number of weeks and we're working closely with the Navy in their investigations on those incidents to really make sure we've got down to root cause and get that nailed down. I think if you've been following it, you saw that the Navy just recently stated that they do not believe that there were any systemic issues, but we really want to sort through that and make sure we've got all of the issues nailed down. We did just receive the ATP on the new Fire Scouts, the MQ-8Cs, and we got started off with 2 demo of the 8Cs as well as 6 production units. So we're continuing to see strong support for Fire Scout and the unique mission capability that it brings.

The next question comes from the line of George Shapiro, Shapiro Research.

I wanted to get at this margin question maybe a little differently. I mean you've done a great job in executing it, pretty much saying what you're going to do in the business, Wes. But at some point, these older favorable contracts and the newer ones seem to have tougher terms. Your margins are higher than virtually anybody's seen in the industry. Now does the declines forecast, Jim, in your guidance for the remainder of the year suggest that we're actually getting to that point of crossover where it's going to be much tougher to get cume adjustments, or is it just your conservatism?

George, you're calling me conservative. In all honesty, George, if we knew that we were going to have earnings adjustments, we would be booking them today. So the nature of the process again is to manage the business. You need to continue to drive affordability across the organization. That goes to our cost, how well our suppliers perform, whether or not there are issues that we have to address from that side, the overall contract. Yes, the business is more difficult. Maybe that influences my view on what could happen here in terms of overall margins, but -- and I stand by my earlier comments. The team is really working hard, first of all, to make sure that we have an affordable cost structure; to be innovative in how we manage, not only the production process, the engineering process, all of which have an impact on affordability or the cost of the products. And again the management process around good deals to begin with is really important.

Yes, George, just one other little piece I would add to that is, as I said in my remarks and I know Jim did in his as well, we're working very aggressively on cost reduction in our enterprise. And we need to do that to support what our customer's needs are, particularly as their acquisition strategies have shifted more towards the low-cost, technically acceptable approach. We need to do that to be competitive for the long term. As we take costs out, there is always an opportunity for that to better support contracts that are already underway, but as you know, in our industry, when we go to compete and whenever we go through a new contract negotiation, the costs we've taken out becomes the baseline for new contracts. So that's also the part of our thinking as we look at sustainability and margin rates in our industry going forward.

And the final question will come from the line of Robert Stallard, Royal Bank of Canada.

I just have a follow-up actually on George's question there. Do you get the sense that your customers are feeling a little bit uncomfortable with this sort of rates of return that you're now achieving, or are they more focused on other things such as price per unit as opposed to returns per unit?

Yes, I think that, ultimately, the customers are focused on affordability. And that's the price they're paying per unit. And in fact, if you listen very carefully to what is being said at the highest levels of the Pentagon, they feel good and they are able to enter into a contract that they deem, through their own analysis, to be very affordable. Clearly, it needs to meet the regulations of DFAR, but contracts that really incentivize contractor performance. And what you're seeing, and when we're talking about making positive adjustments, you're seeing contractor performance and that translates into benefits for the customer. They're getting what they're wanting out of these contracts. So to the extent that we are performing and making good margins, I think there's a lot of support for that particularly when it means that we are, in part, doing that because we are becoming even more cost competitive and we're supporting the future affordability of the defense industrial base. So yes, our customer's under a lot of pressure and not every action that's being taken in response to that pressure or actions that we like, of course. But I think, philosophically, and I base this on the direct statements that come out of the seniors in our customer community and I think these are very, very honest and direct statements, they like it when we perform on contracts and they're willing to have contracts that motivate us to do that.

Well, thank you. This ends our Q&A session. And at this point in time, I'd like to turn the call back over to Wes for closing comments.

Thanks, Steve. Well, I'll just wrap up by saying once again we really appreciate all of your interest in our company. We are continuing to focus on our key priorities as we've talked a lot about here: driving on performance, deploying our cash effectively and optimizing our portfolio for the future. Thanks, everyone.

Ladies and gentlemen, this concludes today's conference. Thank you again for participating. You may now disconnect, and have a great day.