Good day, ladies and gentlemen, and welcome to Northrop Grumman's Fourth Quarter and Year-End 2020 Conference Call. Today's call is being recorded. My name is Shelby, and I'll be your operator today. [Operator Instructions]. I would now like to turn the call over to your host, Mr. Todd Ernst, Treasurer and Vice President, Investor Relations. Mr. Ernst, please proceed.

Thanks, Shelby. And welcome to Northrop Grumman's Fourth Quarter and Full Year 2020 Conference Call. We'll refer to a PowerPoint presentation that is posted on our IR web page this morning. Before we start, matters discussed on today's call, including guidance and the outlook for 2021 and beyond, reflect the company's judgment based on information available at the time of this call. They constitute forward-looking statements pursuant to safe harbor provisions of federal securities laws. Forward-looking statements include 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. Our GAAP results reflect the mark-to-market method of accounting for our pension and other post-retirement benefits. Our references to adjusted earnings and adjusted earnings per share on today's call will refer to earnings and EPS adjusted for mark-to-market impact. We also refer to adjusted free cash flow defined as operating cash flow, less capital expenditures and plus the proceeds of the sale of equipment to a customer and the after-tax impact of discretionary pension contributions. These are non-GAAP measures defined in our earnings release. Our 2021 guidance assumes the intended IT Services divestiture closes very soon. On the call today are Kathy Warden, our Chairman, CEO and President; and Dave Keffer, our CFO. At this time, I'd like to turn the call over to Kathy. Kathy?

Thank you, Todd. Good morning, everyone. Thanks for joining us today. I want to congratulate the Northrop Grumman team for delivering outstanding 2020 results. I applaud our employee support for one another, our customers and our communities in the face of 2020's multiple challenges. Together with our suppliers and partners, we operated through the pandemic, executed well on our programs, maintained superior performance on critical global security missions and one program that strengthen our foundation for the future. We began 2020 operating in a new sector structure, which further aligns our unique capabilities in Space, Missiles, Advanced Weapons, Mission Systems and Aeronautics. This alignment enables the capture of additional revenue synergies, particularly in Space and Advanced Weapons, as well as continued identification of operating synergies. Our 2020 results are tangible evidence that our strategy is creating value. We had exceptionally strong fourth quarter operational performance. And for the full year, we had strong bookings, exceeded the high end of our guidance range for sales, EPS and adjusted free cash flow and delivered strong segment operating income through continued focus on performance and operating efficiencies. For the third consecutive year, we achieved a book-to-bill greater than 1. New awards in 2020 totaled nearly $53 billion or 1.4x sales, and total backlog increased 25% and to $81 billion. Sales rose 9% to $36.8 billion, and segment operating margin rate was 11.4%. Adjusted EPS increased 11.5% to $23.65, and adjusted free cash flow increased 18% to approximately $3.7 billion. All 4 sectors captured important new awards, hosted higher sales and operating income and sustained strong operating margin rates. As expected, our Space business, in its new configuration, led growth in backlog and sales. 2020 results demonstrate Space Systems' growing ability to drive the development of innovative and affordable offerings for our national security,…

Okay. Thanks, Kathy, and good morning, everyone. I also want to thank the team for their outstanding performance in the fourth quarter and the full year. I'll spend a few minutes on 2020 results and then discuss our 2021 guidance in more detail, including the planned effects of the IT services divestiture and the latest updates to our pension metrics. Beginning with the highlights on Slide 3. We exceeded the high ends of our guidance ranges for revenue, adjusted EPS and adjusted free cash flow in 2020. Revenue grew 17% in Q4 and 9% for the full year as a result of our robust bookings over the last 2 years and our team's strong performance across all 4 sectors. The potential upside in AS sales that we noted last quarter did occur in Q4 as we booked a $444 million equipment sale in our restricted portfolio. Revenue growth for the quarter and the year were quite strong, even excluding this unique item, especially in light of impacts from the continuing pandemic. As shown on Slide 5, our mark-to-market adjusted EPS grew 17% from Q4 of 2019 to Q4 of 2020, driven by $0.42 of segment performance, as well as $0.35 of net pension costs and $0.21 of tax, interest and other items. Slide 6 shows the full year view. Adjusted EPS grew 11.5% in 2020, driven again by segment performance and net pension costs with higher net interest expense, partially offset by tax, share count and other items. Referring to sector results on Slide 7. Aeronautics Systems sales rose 24% for the quarter and 9% for the year, largely due to higher levels of restricted activity in both periods. Higher restricted volume reflects in part the equipment sale I noted. The $444 million of revenue was booked in Q4, along…

[Operator Instructions]. Your first question is from Seth Seifman of JPMorgan.

I wondered just with the divestiture, is the long-term plan to sort of maintain Defense and Mission as kind of 2 separate segments? And how would we kind of think about the long-term growth prospects in Defense given that you've got IBCS and AARGM in that segment?

Thanks, Seth. So when we look at the portfolio of Defense Systems, as you point out, it is consisting of our command and control as well as our offensive and missile systems capabilities. And so we view that area as one that will continue to grow. It's very well aligned with our customers' highest priority areas, both domestically and internationally. And we have made the portfolio decision we have to divest our IT services business so that we could focus more fully on those businesses in our Defense portfolio. On the other hand, Mission Systems, which contains a significant quantity of open architecture, networking capabilities that are really keeping pace with the advancing threat environment to be able to help our customers compete in the electromagnetic spectrum, those capabilities are also areas that we see well aligned and core to growth. So we want to keep that team focused on investing and staying at the forefront of technology to different areas of focus. But certainly some synergy and those two teams work well together, but I don't see need for a different alignment to make that kind of working relationship productive.

Your next question is from Carter Copeland of Melius Research.

Dave, I wondered if you could just expand a little bit on this AS equipment sale, how should we think about the accounting treatment of that? Is that something that you just sort of book and shift in a quarter? Or is it cost on cost? Or do you recognize the revenue when you make the sale? I'm just trying to think about the cost of whatever that was and how we should think about that. Just any clarity on that would be helpful.

Sure. Thanks, Carter. It's -- as we mentioned, relates to a restricted program. So there's a limited amount we can say about that. What I would be able to say is this is equipment that, as we mentioned, was booked in the past as capital expenditure. We've now sold that equipment to a customer. And as appropriate, both revenue and the portion of the cash that we've received in the quarter, in our 2020 results, little over half of the cash is to be paid in 2021 and will be booked in as part of our cash flow in the 2021 outlook. From an accounting perspective, it's a somewhat unique item, but a customer transaction and with revenue accordingly, as we mentioned, minimal profit associated with it, which is why you see the margin impact on AS and the outstanding growth that it delivered in the quarter.

Your next question is from Sheila Kahyaoglu of Jefferies.

Maybe, Kathy, for you, just bigger picture, Northrop is one of the only primes where consensus doesn't have any major margin improvement baked in. How do you think about your profit profile of your business, given at least 20% is in development or low rate production? Can you give us a little bit more color? Do you see profit rates improving over the next few years?

Thanks, Sheila. We clearly, this year, have guided some margin rate expansion and there are a number of factors contributing to that. First and foremost is the strong performance in the operating businesses that we delivered both in 2020 and that we anticipate in 2021. That will continue to be a focus for the company. We also have been increasingly orienting our business to agility and streamlining and COVID-19 helped to accelerate some of those initiatives in 2020, again, resulting in good rate management and cost reduction. And those operating efficiencies, we expect to continue as we move forward as well. And then finally, as you note, we do have mix headwinds as we bring in more early phase development work. Of course, those are generating increasing margin dollars but create pressure on margin rate. And we've challenged the team to look at offsets to that mix pressure through just strong performance, operating efficiencies and future changes that we might make in the operating structure that enable us to continue to find new ways of reducing cost. So those are the areas that we are aligned to. And as you see in our guide, we were, in 2021, able to, across the portfolio, really offset many of those margin headwinds that we see.

Your next question is from David Strauss of Barclays.

Dave, wanted to ask about free cash flow. I appreciate all the moving pieces there. But it looks like when I net out the pension side, divestiture side, tax, everything, you're about in the same place as you ended 2020, around $3 billion, but that included a fair amount of working capital -- positive working capital in 2020. So are you assuming positive working capital again in 2021 or contribution from working capital in '21? And how sustainable is that looking beyond '21?

Sure. Happy to talk through that. I think you named the right kind of nonoperating or unique drivers from '20 to '21, free cash flow, the divestiture, the CAS pension headwind and then the reversal of the payroll tax benefit from 2020. And you're right that when you add those 3 together, it's greater than the reduction in our outlook from 2020 to 2021. So it does require us to make continued working capital improvements in 2021. The good news there is we believe we're on track to do so. We expect to continue to be able to generate working capital improvements really across our businesses. We have some targeted areas of performance improvement that we're driving in 2021. And we'll -- this is not a point in time effort. This is a long-term effort that will remain a focus of the company. So to your question about years thereafter, we will continue to drive efforts around working capital efficiency in '22 and beyond.

Your next question is from Jon Raviv of Citi.

Similar question, just sort of thinking forward about organic growth when you did 9% in 2020. You're talking about 4% in 2021. And there are some moving pieces there with the equipment sale, I think. But just this idea of sustaining growth, given where your backlog has been, given where your bookings have been, on whether there's an opportunity to actually accelerate as things like B-21, GBSD, AARGM, ICBS, all kind of start to hit their stride?

Thanks, Jon. So as we look at growth this year in 2021 and beyond, we see the opportunity for continued growth based not only on our backlog but also new programs. I outlined some of those in my earlier comments that we see being awarded this year. As budgets appear to be flattening out, our portfolio would have the opportunity for sustained growth through programs like GBSD, which is at the early stage of its ramp, as well as a number of our restricted programs. It very much will be determined on what funding priorities come from the new administration and how those might play out over time. But we can clearly see forward this year and are projecting another strong year of growth in 2021, and based on the strong support for our programs in the 2021 budget, are equally optimistic that we have a path to growth beyond this year.

Your next question is from Cai von Rumohr of Cowen. We'll go to our next question from Kristine Liwag of Morgan Stanley.

Kathy, can you provide more color on your framework of how you think about sustainability? With your planned divestiture of the testing business for cluster munitions, where do you draw the line? And do you anticipate more divestitures from this initiative?

So Kristine, when we look through the lens of sustainability at our portfolio, we look at not only what capability we're providing, but how it's being used or how we expect the customer to use that capability going forward. And the decision in this case, with our small contract related to cluster munitions, it was a surveillance program. It was actually structured to help remove cluster munition safely. However, we recognize that even supporting area like cluster munitions for investors is of concern because safe removal implies that at one point, there was an embracing of the use of these products. And so when we look at our portfolio, we are going to continue to recognize. We support our government and our allies in the important work of enabling our troops to do their work. But at the same time, be thoughtful about potential human rights implications and how these technologies may be used in the future and provide equal consideration to safeguards associated with them. In answer to your question, I don't expect there to be significant change in our portfolio as a result. We already have a portfolio where we have looked through that lens and making decisions about where we invest and what work we undertake. This was just one small contract that came to us through the acquisition, and we've made a decision to stop performing in that area.

Your next question is from Ron Epstein of Bank of America.

Kathy, could you speak to the B-2 defensive management system? And is that nearing completion? I mean, how -- where does that program stand in the big picture vis-à-vis B-21 starting to ramp up a little bit? How should we think about that?

Well, taking a step back from the defensive management system, which is completing this year. We are looking at modernization of the B-2 so that it can stay in service through the successful transition and replacement of B-21, which, as you know, doesn't happen and it doesn't start to happen until later in the decade. And so B-2 modernization as a broader program will continue, but the DMS program is one that is expected to complete this year.

Your next question is from Myles Walton of UBS.

Kathy, I was wondering, competition is always changing and there's new competitors entering all the time. But I'm curious with the confluence between Palantir now at $70 billion and an administration geared towards inserting new technology, commercial-based companies into the landscape of competition. Is it evolving quickly? Or is the market just thinking it's evolving quickly in terms of the competitive landscape?

We certainly see new entrants coming into the space. And in the case Palantir, they've been in the space for a number of years. And we are, in many instances, working with those companies. Because a company like Northrop Grumman brings scale. We bring understanding and mission. We bring technology in our own right in areas like artificial intelligence, machine learning. We have a business that is bigger than many of the smaller companies already embedded inside of our company in these areas. But there also is opportunity to partner and learn because the technology is moving so rapidly. And it's what's creating these new market entrants. There's room for more players in the industrial base and good ideas to build upon one another. So the partnering strategy that we have works to embrace those small companies and bring them into an ecosystem along with us to solve our customers' problems at scale. I've talked in the past about pitch days that we've been doing in certain areas. We've done artificial intelligence. We've done autonomy, to name a few. And we have hundreds of companies that are participating in these engagements with us to talk about how we might together solve our customers' hardest problems.

Your next question is from Doug Harned of Bernstein.

We've seen kind of history on -- recent history in government IT where scale has been very important. We saw it with Leidos. We've seen it with GDIT. When you made the decision to make the sale of some of your IT businesses to Peraton, can you talk about how you're thinking about this in terms of scale? It appears that you didn't really sell any national security-related capabilities. But how do you do the trade off? I know you know this business really well. So how do you think about the focus going forward in government IT?

The business that we divested does have national security work, Doug. It's across a broad spectrum of customers, including federal civilian as well as Department of Defense and intelligence community. And we packaged our IT services business together, as you note, across 3 different businesses because this is an area that we are going to be less focused on and we wanted to get that business into the hands of an organization that wants to invest and to build scale. And I agree with your assertion that in the IT services business, scale is an advantage. And Veritas has the vision that you see playing out even most recently with their announcement to acquire Perspecta and put all of these businesses together. So we are confident that they are the right owner for this business, that they have a vision for it, that they have a commitment to invest and that they will be a good employer for our employees who will transition.

Your next question is from Robert Stallard of Vertical Research.

Kathy, quick question for you. The administration seems to have put the Middle East arm sales on whole for now. I was wondering if there could be any implications for you, particularly if you have any exposure on the offensive side?

We have a small piece of work that was in consideration, had not yet been approved. And so it is not work that was approved and is put on hold, as you've read about the F-35, for instance. What we do anticipate is an extensive evaluation of everything that was in the pipeline, which will include some of our work. And of course, as you well know, we're embedded in the F-35 as well, but I'm talking about some of the arm sales that we would have been prime on and that are particularly related to our weapons business, which was the genesis of your question. It was small. It was related to AARGM, and it is something that does not have a material impact on our plans. But we do expect that those will all be reviewed. And we, along with you, will learn what this administration's view on those exports will be.

Our next question is from Robert Spingarn of Crédit Suisse.

Kathy, I'm hoping I can ask on this because the Air Force already talked about it. But on B-21, Will Roper, the outgoing Air Force acquisition chief, made some pretty positive comments recently with respect to first flight, indicating that even though it's now going to be mid-'22, it's going to be of a production-ready aircraft rather than a prototype and then you can move pretty quickly into low rate and then full production. Since that's out there, I wanted to see if you could talk about the margin profile and the margin opportunity here, given that this aircraft is so far along.

So I can't speak specifically about the margin profile or the specific time line of transition from one phase to another. But what you picked up on from Dr. Roper and there was also a piece that was based on an interview with Randy Walden on the B-21 is the confidence that the customer has in the development progress and the ability to manufacture this aircraft and have a capability at first flight that is more mature than previous aircraft development programs. And we're doing that through a number of ways, the digital engineering and the digital thread that we have on the program. The testing of hardware and software on a surrogate test bed and the thinking about maintaining and manufacturing in the early phases of design as well as the interface with the end user. The pilots who will fly this aircraft have all helped to really mature the production-ready articles that will be tested in those initial phases and should significantly reduce rework, which is, in itself, schedule, certainty and reduced cost. So that's what we expect based on the progress that we're making at this point, and it's what's underlying the confidence that those customers are expressing.

Your next question is from Peter Arment of Baird.

Kathy, maybe just a question on kind of the CapEx profile you expect over not only this year, but next, I mean, CapEx was up 12% in absolute dollars and 2020. And also, your internal R&D dollars were up 13% on an absolute basis. How should we think about both of those? And just in the context of all the program wins that you've had and just the success on the overall portfolio?

Sure. Peter, it's Dave. I'll address that one. As you mentioned, the 2020 CapEx figure was around $1.4 billion and that's a comparable level to what we've projected into 2021, the netting effect then being the equipment sale we talked about earlier, which also flows through that investing section. So on a net basis, it's actually a bit below our prior guidance for '20 and '21. Beyond '21, the trend that we've talked about over time remains our intention. Where the CapEx as a percentage of revenue should decline, we see opportunities to continue making prudent investments in our business and our capabilities and technologies but at a slightly lower level of overall investment than has been required over the last few years and into 2021. So no change to that long-term approach. The same would apply on the R&D side. We've had -- we've been investing amply in the business, close to 3% of revenue over the recent past and into the near future and we'll continue to invest in those differentiating technologies and capabilities.

Your next question is from George Shapiro of Shapiro Research.

Yes. I wanted to know, is the GBSD supposed to add about $1 billion of revenues this year, Kathy, like you had suggested on the Q3 call?

So George, we have said nearly $1 billion. It's a little less, I would think, more in the $800 million to $900 million of incremental revenue.

Our next question is from Hunter Keay of Wolfe Research.

It's actually Mike Maugeri on for Hunter. Dave, you mentioned mid single-digit organic growth at Mission Systems. So within that organic portion, what are just some of the bigger moving pieces embedded in that guide?

Sure. I'll be happy to kick that one off and Kathy may want to jump in as well. The MS portfolio, as we've talked about over time, is difficult to pin down to any 1 or 2 key drivers in a given year. Like most years, we have a lot of programs with opportunities for growth across the MS portfolio. Certainly, the radar capabilities, targeting capabilities, the cybersecurity capabilities are key growth areas there. We've talked about a couple of the key potential new business opportunities like 3DELRR and others in the MS portfolio. So a nice breadth of opportunities across MS, similar to 2020 when we had growth across all 4 of its business areas. So absent the divestiture in '21, another solid year projected ahead. Kathy, anything you would add to that or on the MS portfolio?

That's a good summary.

Okay.

Your next question is a follow-up from Jon Raviv of Citi.

So just following on the sales question that I had. Any headwinds to watch out for? I know there's, for example, a distributed aperture system cut over at some point in F-35. But just sort of anything else that we should just be cognizant of going forward?

So I can talk a bit about that. We mentioned the approximately 4% organic growth figure when you remove the divestiture as you compared 2020 to 2021. So 4% organic growth, that's even with the CAS pension headwind that we mentioned earlier, which is just under 1%. That also includes the impact of Lake City, which is just over 1% of revenue as it came to a strong conclusion in 2020. Those are the two most significant items, and I wouldn't call your attention to any one particular area of recompete exposure looking forward, either in aggregate. We feel really good about the program backlog and don't have anything approaching that 1% headwind level other than those that we've mentioned.

We have time for one more question.

We had Cai von Rumohr of Cowen return to the queue.

Yes. So a great year in bookings in 2020. If we adjust your year-end '20 backlog to exclude the Northrop IT business that you're selling, do you look for backlog growth in 2021? And what are the key drivers there? What are the end new program competitions that could add to that backlog?

So Cai, we do expect to have book-to-bill around 1 again in 2021, and that is through some new awards like NGI, 3DELRR. It also includes bookings on key programs like F-35, the next block buy, so it's spread across the portfolio in each of our sectors. We expect to have solid awards in 2021. All right. So thank you for hanging with us. We tried to get through as many of your questions as possible, given how much we had to cover today. Again, I want to thank the Northrop Grumman team for another outstanding year. We performed extremely well in the midst of many challenges last year, and we're well positioned for 2021 and beyond due to that strong performance, our continued backlog growth and the value-creating portfolio actions that we've been taking. With our cash on hand and strong cash flows, we're committed to thoughtful deployment of that capital to create long-term value for our shareholders. Thank you, all, for being with us today, and that concludes our call.

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