Good day, ladies and gentlemen, and welcome to Northrop Grumman's Fourth Quarter and Year-end 2018 Conference Call. Today's call is being recorded. My name is Natalia, and I will be your operator today. [Operator Instructions]. I would now like to turn the call over to your host, Mr. Steve Movius, Treasurer and Vice President, Investor Relations. Mr. Movius, please proceed.

Thanks, Natalia, and welcome to Northrop Grumman's Fourth Quarter and Full Year 2018 Conference Call. We will refer to a PowerPoint presentation that is posted to our IR web page during Ken Bedingfield's remarks. Later today, we plan to post an updated corporate overview to the Investor Relations webpage. Before we start, please understand that matters discussed on today's call, including guidance, expectations and current thinking on revenue, earnings and cash trends, constitute forward-looking statements pursuant to safe harbor provisions of federal securities laws. Forward-looking statements involve risks and uncertainties, which are noted in today's press release and our SEC filings. These risks and uncertainties may cause actual company results to differ materially. Matters discussed on today's call will include non-GAAP financial measures that are reconciled in our earnings release and supplemental PowerPoint presentation. Specifically, as of December 31, we adopted the mark-to-market method of accounting for our pension and other postretirement benefits. For consistency and comparability of our results and 2019 guidance, our references to adjusted net earning and adjusted earnings per share on today's call will refer to earnings and EPS adjusted for the mark-to-market impact. These are non-GAAP measures. We define mark-to-market adjusted net earnings as net earnings excluding the impact of mark-to-market expense or benefit and its tax-related impacts. We believe the supplemental measure is useful as it depicts our results before the nonoperational impacts of pension and other postretirement benefit actuarial gains and losses, and is consistent with how management measures underlying performance, determines incentive compensation and provides guidance. Table 1 in the earnings release reconciles non-GAAP operating measures to our GAAP results, and Schedule 6 of the earnings release provides recast historical information for years 2016 and 2017, and quarterly recast information for 2018 for the mark-to-market method of accounting. On the call today are Kathy Warden, our CEO and President; and Ken Bedingfield, our CFO. At this time, I'd like to turn the call over to Kathy.

Thank you, Steve, and hello, everyone. Thanks for joining us today. In addition to reviewing our results and highlighting some of this year's important operational achievements, I'll discuss our outlook for 2019 and also provide some color on how we're currently thinking about trends into 2020. First, I'll thank our Northrop Grumman team for their continued focus on performance and growth. The efforts of our employees enable us to continue delivering excellent outcome through our customers and shareholders. 2018 was another strong year for our company. This year's capstone achievements was the completion of the Orbital ATK acquisition in June and the stand up of Innovation Systems as our fourth sector. The transaction was immediately accretive to earnings, and I'm very pleased to report that as we continue to successfully integrate IS, we are on target for cost and operational synergies and trending favorably on revenue synergies. The addition of Innovation Systems, along with the organic growth at Aerospace Systems and Mission Systems, drove a 24% increase in fourth quarter sales and a 16% increase for the year. I would also note that 2018 international sales increased to $4.4 billion or 15% of total sales, reflecting growth at all 4 of our sectors. Our strong sales growth in those periods, coupled with segment operating margin rate expansion, drove a 43% increase in segment operating income to more than $925 million in the fourth quarter, and a 19% increase for the full year. In addition to the contribution for IS, operating income increased at all three legacy Northrop Grumman sectors in the fourth quarter, and segment operating margin rate increased to 11.4% for the quarter and 11.5% for the full year. Adjusted earnings per share for the quarter increased to $4.93 per share and 2018 adjusted earnings increased by more than…

Thanks, Kathy, and good afternoon, everyone. I also want to thank our team for this year's strong performance. Today, I'll spend a few minutes on 2018 results, and also discuss our 2019 guidance in more detail. As I review 2018, I'll remind you that prior periods are recast for adoption of the accounting standard updates for revenue recognition and pension cost presentation both adopted at the beginning of 2018. We also recast for our previously announced mark-to-market pension accounting change. Turning to sector results. Aerospace Systems sales were up 6% for the quarter. 2018 sales grew to more than $13 billion, up 8%. While restricted activities and the F-35 program of Manned Aircraft drove a substantial amount of the year-over-year increase, all 3 AS business areas, Manned Aircraft, Autonomous Systems, and Space, posted higher year-over-year revenue. I would note that the top line of AS has grown about 30% since 2015 and that the team has done a great job of maintaining strong performance while managing rapid growth. AS operating income increased by 12% in the fourth quarter and 9% for the full year, driven by sales growth and improved performance for Manned Aircraft and Autonomous Systems. For the full year, we achieved a strong 10.8% margin rate, again principally driven by Manned Aircraft and Autonomous Systems program performance. For 2019, we expect AS to grow its top line at a mid-single-digit rate to the high $13 billion range. Our top line guidance calls for continued growth in all 3 business areas. We expect a mid- to high 10% operating margin rate at AS in 2019. At Innovation Systems, based on pro forma sales comparisons, fourth quarter sales rose 7% due to higher volume at Flight and Defense Systems. For the year, sales increased 17%, driven by growth in all…

Thanks, Ken. [Operator Instructions]. Natalie, will you open the line?

[Operator Instructions]. Your first question is from the line of Rob Stallard with Vertical.

So Kathy, a question on your comments. You said that in the Manned Aerospace area, the restricted program -- a restricted program, was expected to level off this year. Can you give us some idea of how this area is expected to progress beyond 2019? Are revenues likely start to accelerate again from 2020? And is there any change in the margin profile as well?

Rob, I appreciate the question. I'm limited in what I can say about the program to which I'm referring, but I did want to provide all of you some insight into how it factors into our current year guidance, 2019. And so my comments were, that we see sales leveling off, and that, that is consistent with what we would typically see in a program that's executing well and is completed its critical design review. Beyond that, I really can't comment any more on what we expect, either in future years or about the performance of the program.

Okay. Can I try something else instead, then?

Yes.

Okay. You mentioned Innovation Systems at the export side of things are seeing some strong growth this year, stepping down again 2019 and going back up again. I was wondering if you could give a bit more clarity on what exactly those products or services are that are moving around.

Rob, I would just say that we had some strong growth in 2018, largely on the defense systems side of the business related to some munitions and other weapons programs. And those ramped up in 2018 and are starting to ramp down here in early 2019, largely just driven by timing of the orders and then the deliveries were made. And we do expect that we'll see a continued strong growth out into 2020 and beyond. So just timing, but good programs and good opportunities as we look forward.

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

You gave us a little bit of color based on trends on revenue and EPS into 2020. Can you speak to like the cash flow trend as we think about that with kind of what you would expect free cash flow to do? And then, there is an expectation, I think, among investors, that at some point, you will see growth accelerate above where it is, given the programs you're on. How should we think about that? And I guess, that's probably [indiscernible] your question, but at least if you could give us some flavor on that.

So Ron, it's Ken here. Maybe I'll take it in reverse order. In terms of the growth profile, I would say that yes, we're very happy about how we're positioned, I would say, very closely aligned with the National Defense Strategy, National Security Strategy, missile defense review, and other areas of focus for our country that deals with this ever-increasing view of threat from peer, near-peer countries. And we do expect that, that will drive a nice growth profile as we look out past '19 and past 2020. At this point, I wouldn't want to put a number on it, a lot of moving parts between here and there. And I would say that ours is a long cycle business, and it takes time to generate revenue out of some of these awards and move some of these early developments. This early development growth we're seeing out of the NDS and other areas and turning those into ultimate production. And you want to take your time. You want to get it done right. You don't want to perturbate your production lines or your factories just to try to drive volume for a short period of time. So we take a measured long-term approach to it, and we're quite satisfied with the profile we see. From an EPS perspective, again, we do see strong growth. Kathy mentioned what we saw the length of '19 to '20. And from a cash perspective, obviously, the longer you go out, the harder it is to predict from a cash basis. But we do think that this is a strong cash-generating business that we ought to be able to generate, turn our earnings into cash as we think about our working capital. Just as maybe one example, we see working capital in 2019 probably growing with sales. And then, in 2020, we see, potentially, some opportunity to reduce some working capital as we have some programs that we invested in, in the past that should start to generate a better cash profile. And then, I mentioned a couple of other things, including relatively low level of CAS funding and a declining amount of CapEx in dollars as well as in a percentage of sales. And I would just encourage you to take that information and use it to model what you think our cash would look like. We're probably not going to put a number on it beyond 2019 at this point.

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

In terms of -- on AS, can we talk about margins and leverage a little bit coming in light? What mix factors are driving it? And how do we think about it in '19 and beyond?

For AS, from a margin perspective, Sheila, I would say we're quite happy with how that team has been performing. They've taken on a lot of early phase development work and they've maintained strong margin rates throughout. As we look at 2019 guidance for margin, and maybe looking out beyond as well, I would say, we're guiding '19 kind of in the range of where we were in 2018. And the biggest drivers of margin, obviously, are mix and performance. So if that team continues to perform and we're able to continue to burn down risk and realize opportunities on some of our programs, we could see some additional upside as we look out from a margin rate perspective. I would just point out that AS sectors taking on some additional early phase development opportunities, is not just the one program that people tend to think about. And so that will continue to certainly provide a generation of growth for future production, but also probably keep margin rates somewhat range-bound to where we see it today, of course, with the risk and opportunity management providing some level of upside as I mentioned earlier.

Your next question is from the line of Noah Poponak with Goldman Sachs.

So I want to come back to this topic of your target or commitment to outgrow your end market on a multiyear basis. And I don't know where you'll go, given what you've said so far here. But it didn't happen in 2018. 2019 up -- call it up 5 organically isn't quite -- based on what it looks like, authority steering, translating outlays, based on what some of your peers are doing, it's not really definitively happening in '19. The comment of mid-single digit in 2020 sort of, again, based on what it looks like outlays are going to do and what some other companies are saying. It kind of looks like a 3-year window here of that comment of outgrowing your end market actually not really happening. And I know you have the transitory, you could call it transitory TS stuff in there, for part of that time. I don't think you have that in 2020. And so from where we sit, we just constantly get the question from investors, what specifically do they mean by the end market? What specifically is the variance to the end market? And why isn't it happening in realtime as you are projecting that for your business?

Noah, I'll start, and Ken can add in as well. When we look at the growth trajectory of our business, we do look at it over the long term. And we talk about long term, our business cycles, particularly with AS and, to a lesser extent, IS and MS, tend to be beyond 3 to 5 years. And so when we win a large program, it takes time for us to ramp up to a normalized state of revenue generation for development. And then, that tends to plateau a bit before we get into the production phase where there's another ramp process that goes on. And what you've seen from us over the last couple of years is some significant ramps associated with taking on new work. Those, when we talk about long term, we're really talking about 5-plus years. And so in any given year, you may not see a year-to-year transition at the equal rate of growth as you did in the past. And so that's what we mean when we talk about long term. Now let me talk about where we are in the alignment with the NDS. We are seeing new programs come into the portfolio. They start relatively small, and so they are not moving the needle with the same rate as some of our large programs that we have talked about. But they do create the platform then for growth to 3 to 5 years out. And so that's what we wanted to give you a sense of in terms of not just talking about 2019 guidance, but the trends that we see into 2020. And over time, you will see those develop into more material program that represents the growth that we've been talking about on a long-term basis, an alignment with the investment account.

Yes. I mean, I guess it sounds like it's a high -- maybe, a very high degree of confidence in duration that you can see with substantial visibility, maybe even beyond five years down the road that you are sustaining the current growth rate versus a big step function at some point in the pace.

When you have long cycle programs, you tend to look at them over a decadal view rather than a given annual view. And so yes, that is what we're talking about. And of course, there's uncertainty that comes with that in terms of the commitment to those programs over the long term, which is why we don't tend to guide more than a given year. However, we have seen good alignment in the National Defense Strategy to the programs that we are talking about that create that foundation for our view that we're well aligned. And the threat environment is really what drives our confidence that we have the portfolio that lines up well, not just for today, but into the future.

And Noah, I would just add, I think your comment is on point. You certainly want to think about your production rate and production lines, and how much you might have to invest to drive that capacity sooner rather than over the next couple of year period. I would just point out that if you think about it, AS has been growing significantly, right? 30% since 2015, nice growth in 2018. Obviously, IS had a great growth rate in 2018. MS, if you exclude some of their headwinds from JRDC and our restricted ISR program has grown about 6% in 2018. We're looking at probably 6% in 2019. And TS, we expect will be in the low $4 billion range in '19, and then, flatten and start to grow in '20. So I think, overall, we feel pretty good about it. I think you're right, there's a real nice long-term trajectory here. And I would just think about it a little bit in that bigger sense in terms of how restructure was doing as well as we talked about the international business at IS, that as a part of that big 17% revenue growth that's going to have a little pause here in 2019.

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

Just one quick one, and then, we're off of revenue. Just talk about a simplifying assumption, Kathy. Just looking at the Q4 commentary, you didn't call out any big risk retirements of significance in AS, but obviously, you went through the B-21 critical design review successfully. Is it safe for us to assume that your performance was approximately in line with what you had assumed? Or is there any reason to think that, that wouldn't be the case?

That would be a fair assessment, Carter. When we think about programs and our booking rates, we take into consideration what we know about performance. And so we tend to incentivize the team not to have large variation. And when they are performing well, there is very little volatility in our booking rate position, based on performance.

Okay. That's what I would have assumed. I just wanted to make sure there wasn't something missing.

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

I wanted to talk about Aerospace Systems for a moment, and just, you mentioned some of the components in terms of F-35. I think you said mid- to high single. And then, if Manned Restricted is not growing, I would think that kind of takes the whole segment down further. And so if you think about the other pieces there, sort of what's enabling you to get to kind of the 5% to 6% that you're forecasting.

Thanks for the question, Seth. I would say, yes, if you think about it, we've got F-35 in there at, as we mentioned, mid- to high single digit. We certainly see growth opportunities across the portfolio of autonomous Systems, growth in the Space division, particularly in the area of restricted space, addressing some of the new requirements like resiliency and other things. So largely nice growth across the portfolio at AS. Some new development work that I mentioned, addressing some of the areas of the National Defense Strategy. And then, continued growth in some other production programs. I think E-2D has nice growth in 2019 and beyond. Triton is in production and we see that progressing nicely on a growth profile. And so I think it's pretty diverse across the portfolio there.

And then, maybe just a follow-up real quick. Does F-35 flatten out in '20? And then, you've resumed growth in Manned Restricted?

My thought on F-35 is we should continue to see growth in 2020, probably more in the mid-single-digit range. And that growth should continue. Ultimately, production will level out. And as prices continue to decrease, you would see production reach a peak. But the sustainment volume at that point should start to fill in that gap, and we would expect to see a pretty sustained amount of revenue on the F-35 as we look forward. We do expect that given our position on a program, whether it's at AS or at MS across the various Electronic Systems, that it is only among that we would expect to see our fair share of sustainment revenue over the life of that program.

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

Kathy, you mentioned some consolidation efforts on TS. Maybe you could just give us some further your thoughts around whether you see other consolidation opportunities within TS, any -- either M&A or in particular, portfolio shaping that you're thinking about in 2019 and beyond.

Thanks, Peter. So in TS, I mentioned the consolidation of 2 businesses into 1, Global Services, and that is intended to create a more competitive integrated services portfolio that focuses on high-end services for IT as well as analytics and operations in the areas of cyber, health care, and intelligence. And that business has really, as it's come together, been able to lay out a platform for transitioning to growth after just executing a strategy to get out of lower-end services and IT outsourcing. And so I'm proud of what the team has accomplished there. We now have that segment positioned to begin growing and a competitive set of capabilities and offerings that we can bring to the market. So my intention this year is to enable that team to grow. We, of course, have NTS already been growing in the logistics and modernization piece of the business. And we expect that growth to continue both domestically and internationally. And so the 2 pieces of the business are both aligned through good performance, not just in '19, but in beyond.

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

I wanted you to just help me reconcile the comment earlier about an expectation for revenues to start accelerating more materially, but at the same time, having CapEx start to decelerate pretty materially. Is that just Northrop going through some sort of harvesting process around spending that's been occurring? Or is there something else going on? And then, how would something like GBSD come into play if you were to win that and the implications for the spending side and some of those numbers, Ken, that you provided earlier?

Sure. I wouldn't want to call anything at what we're doing as harvesting. I guess, what I would say is, that, in my view, we saw the ability to grow this business, and we saw the investment it was going to take to position ourselves for that growth and to drive the programs and to drive the performance that we're seeing today. And given those investments that we made, we are able to grow the business off of that investment, or facilities. We've invested in production lines, engineering tools, all those things that it takes to grow the business. So we've invested to get to the trajectory that we see. That's why we're starting to get on to the downslope of our CapEx profile, while we're continuing to see a nice solid growth profile. And with respect to GBSD, we will see potentially some additional CapEx driven by a GBSD win. But I'd expect that will be post-2021 before we would see that CapEx profile. And then, as we continue to grow the business, I don't see it largely perturbating our ability to fit within the out-year profile that I talked about from a CapEx perspective. Could be a blip for a year or 2, but I don't see it largely perturbating our long-term thoughts on that front.

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

Curious if you could give us the total company sales or earnings mix that you say -- that you would say comes from missile defense, post-OA? And what's the growth rate you might expect to generate over the next few years in a base case? And also, best case scenario, knowing what you know about current opportunities and what you expect?

So on our -- I guess, I don't have that particular number in front of me. We are going to post an updated company overview deck to our Investor Relations site this afternoon after the call. And Matt will have a fair amount of detail in it mixed by sector, by division, by major products, and things like that. So I think we do see a nice growth profile from a missile defense perspective, much of it, I would say, at MS and IS. Certainly, IBCS is one that we see having nice growth, both U.S. and internationally. Kathy, I don't know if you want to add anymore on that side of it.

Yes. Hunter, I'd just take you back to the missile defense review and the capabilities that are outlined in there from a space layers and support, tracking and targeting, to the missile capabilities needed and different weapons classes, the counter-hypersonics capabilities required. All of those capabilities are ones that we contribute to through every sector in our company, but as Ken said, most prominently through IS and MS. And so we look at our portfolio through the lens of capabilities, and you'll see that in the company overview, but you'd have to take pieces from every part of the company and assemble them as they would line up against what's being required to support in the full defense mission.

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

I was hoping, maybe, Ken, you can talk a little bit about the IS margins. Year-on-year, you're looking for flat. I think, obviously, the sales came in stronger in '18 than you would otherwise would anticipate it. But the margin is flat year-on-year, given kind of the integration, the synergies, I would imagine if flowing to the business. Can you just talk about that? And also, Kathy, are you still on track for the $150 million of synergy run rate in 2020?

Sure, I'll hit on that this first question, and turn it over to Kathy. I would say that, look, our guide for IS is kind of consistent with where they were for the full year of 2018. We're just 6 months in the integration here. We've forecasted some of those integration costs at the corporate line, but some of those could certainly hit the sector so we're thinking through where those costs are going to flow through. And some of the synergy benefits, whether they're costs, operating or revenue synergies, also will be realized by the other sectors. So you got to look at kind of the bigger picture as all of the sectors will realize some of the integration benefits. And I'll let Kathy comment on the integration process as she's been leading that for us the last year or so.

And yes, Myles, I'm very pleased with where we are on integration, both the cultural integration that's occurring as well as the integration of our operation. As Ken noted, we are on track for the cost synergies that we defined going into '19 and expect to largely have recognized those in early 2020. We are also above our expectations of where we thought we'd be at this point in both identifying revenue synergies and fitting work together that could result in revenue synergy for not just IS, but the other sectors as well. As I look at the process that we took where we are leveraging the best of both cultures and processes into Northrop Grumman, the team has really stepped up and responded. We've been able to continue to perform exceptionally well as you see now in our 2018 results, while also doing the back office integration that's so necessary to being able to operate as one company. And so just seven months in, I couldn't be more delighted with where we are in the integration process.

And Kathy, I apologize. One other comment I should make on IS margin is, their mix is trending a little bit higher towards development work as they're also seeing some volume come out of the National Security Strategy, particularly international space -- national security space business as well as hypersonics. So that drives the margin rate down just a touch, but certainly positions them well for a new future production.

Your final question is from the line of David Strauss with Barclays.

I wanted to follow up on that on IS, and actually about the working capital opportunity there. Ken, I know you mentioned kind of 2020, a tailwind -- potential tailwind for free cash flow from working capital. Can you just talk about how you view that working capital opportunity at IS? Is it as large as it would appear based on when the company was on its own?

As I think about the working capital, I would say that as an industry, we've been building some working capital as we've seen some of the cash terms structurally in the DFARS work a little bit against us, in particular, on some of the longer cycle production programs where deliveries aren't made for, in some cases, years down the road. And we carry a fair amount of working capital until we get to liquidate upon delivery and DD-250 of those products. I would say that legacy Orbital ATK or NGIS saw similar increases in working capital based on that trend. But also, they have some structural areas where they had invested in programs like A350 and in the CRS program. And some of those will start to have a better cash profile as we look at 2020. They also had agreed to make some investments that should start to ramp down here in 2019. And we expect that, that will also have a bit of a benefit on cash as we look at 2020 and beyond. So we're working it both on our side and on the NGIS side. And I think that our team is probably one of the best managers of working capital in the industry, and we expect them to continue to be successful in that regard.

At this point in time, Kathy, I'd like to turn the call over to you for final remarks.

Thanks, Steve. I'll conclude today's call by once again thanking our team for another outstanding year of performance for our customers and our shareholders. I'm just honored to be leading such a talented and dedicated team of men and women at an important time for our company and to our national defense. So thank you all for joining our call today.

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