Northrop Grumman Corp (NOC) 2023 Bernstein’s 39th Annual Strategic Decisions Conference Transcript

Northrop Grumman Corp (NYSE:NOC) 2023 Bernstein’s 39th Annual Strategic Decisions Conference Call June 1, 2023 9:00 AM ET

Company Participants

Kathy Warden – Chairman & Chief Executive Officer

Conference Call Participants

Douglas Harned – Bernstein

Douglas Harned

Okay, good morning. We’re continuing on defense here, and I’m Doug Harned, Bernstein’s senior aerospace and defense analyst. And I’m really happy to again have with us Kathy Warden, Chairman and CEO of Northrop Grumman. I think, Kathy, you’ve got a few words first.

Kathy Warden

I do. Yes. Thanks, Doug. Good to see you all this morning. I’ll start with our Safe Harbor statement. Just to remind you that I may make forward-looking statements in our discussion today, and that those statements come with risks and uncertainties. So I’d ask you to look at our SEC filings for a full disclosure of what those risks and uncertainties are. I’d also just like to provide some context on how the business is going since we were last together.

We had a strong first quarter that we reported a few weeks ago, 6% growth year-over-year. We also returned $1 billion to our shareholders in the first quarter through an accelerated share repurchase program and a healthy dividend. As we look at the business, going forward, we continue to see an opportunity to grow the business at a healthy clip, grow flat cash flows. We’ve talked about our cash flow outlook being over a 20% compound annual growth rate through 2025 and having opportunity to accelerate beyond that time as well. And I’ll talk to some of the reasons behind that.

As we look at the last several weeks, clearly, we’ve all been watching the debt ceiling negotiations and the impacts that, that will have on defense. We’re pleased to see support for the President’s budget and with the House pass last night. And we’re also pleased to see how Northrop Grumman programs fared in the President’s budget submission. And that’s just a piece of the story because as we look internationally, growth opportunities continue to accelerate for our portfolio there as well.

When I think about the challenges that we’ve discussed over the last year, there’s progress being made there, too. Labor certainly has been a positive turnaround story from where we were a year ago. We continue to be able to hire the talent we need to staff our programs and our attrition is back to pre-pandemic levels.

We also have seen progress on inflation and supply chain. The supply chain challenges still are there. I’m sure you’re hearing that from my industry colleagues as well. And you’ll have some questions, I’m sure, Doug, where we can elaborate on that, but we are seeing gradual improvement. And so I’m optimistic that we’ll continue to be able to accelerate growth through this year and into next.

And on that front, really, the opportunity space for Northrop Grumman is rich. We’re seeing the strategic deterrent well supported in the budget. We are seeing growth in our Munitions, Missiles and Missile Defense portfolio, and our Space portfolio continues to be an extremely positive story supporting the long-term growth of the enterprise.

So I’m really happy to be here. And I know we have a lot of topics to dig into, so I’m going to turn it over to you.

Douglas Harned

Okay, great. Thanks, Kathy. The defense budget, if we make the assumption, the debt ceiling, all of these issues are cleared, then we’ve got a top line for the defense budget that’s like the Biden budget. But these budgets don’t get done by the way. So the details of the budget, sometime later this year, we hope. But one of the issues you, I know heard, Lindsey Graham’s commentary, that this budget increase in the Biden budget isn’t enough to really cover inflation. So how do you think of this today? Last year, we saw $50 billion added by the Senate for inflation. How do you deal with this, this year?

Kathy Warden

It is a real issue that we’re glad you’re pointing out. Because while we are supportive of the debt ceiling agreement that supports the President’s budget for defense, which is a little bit more than 3% growth year-over-year, the fact is, that doesn’t keep up with inflation. And so the buying power of the defense department is going to be lower. And as a result, the national security priorities are not being as well supported as I know both parties would like them to be.

The good news is there is bipartisan support for national defense. We see that in Appropriations Bill that’s passed last year, we saw that, again, in support for defense being a growing element of the budget when others were being held flat or even declining in this debt ceiling agreement. So there’s optimism to be had there around the strong bipartisan support. And there are many factors that our government is dealing with, including getting our deficit reined in, that I think, long term, create the opportunity for us to return to more healthy growth rates in defense spending. So those priorities need to be [indiscernible].

I fully support what the administration and the speaker did to come to a resolution. But it is a reality, that given this threat environment, the Department of Defense is needing to make priorities to stay within that 3% growth rate, while also dealing with inflation.

Douglas Harned

No. I mean that often can mean — if they can’t add money, that can often mean pushing some programs out. Is this something that concerns you?

Kathy Warden

It doesn’t concern me. And that when I look at the Northrop Grumman portfolio, it’s well aligned with the highest priorities in the department. The strategic deterrent is already at a point where we need the replacement capabilities with urgency to the schedules that are laid out in those programs of record, and we need them in the quantities that they’re defined. Whether you’re talking about the B-21, where we’re prime, the Sentinel program where we’re prime, or the Columbia Class Submarines where we are a supplier. That entire modernization effort is a high priority and needs stay on pace. They can’t be slowed down. They can’t be stretched out in the quantities. There’s more talk about increasing them than reducing them. So I think they fare well in the budget.

I also see our Space portfolio faring well in the budget because when you look at the capability you can get from space today, economically, it is a better value than other alternatives in operating and other domains. And I think that’s why we’ve seen this massive shift of defense budget into Space. So those areas, I believe, are going to be relatively well supported, and our alignment to those priorities should keep those programs protected while other areas are deemphasized.

Douglas Harned

Another source of money in the budget has been for Ukraine, supplemental spending for Ukraine. Now can you help us understand how Northrop Grumman has played into that? What programs have been related to that?

Kathy Warden

It’s mainly Missile Defense and Munitions. We talked in our first quarter call about having received $350 million or so of awards just in the first quarter. Those were largely missiles and ammunition contracts. When you look at our role, it is largely as a supplier in missiles. It is as the prime and missile defense. We’re on contract for 9 counter UAS systems. We are also producing radars that are being used in Ukraine, and we provide support through many of our platforms to the Ukrainians, while we aren’t delivering those capabilities directly to them. It is creating demand and pull for operational utilization of those platforms, all of which support the sustainment contracts that we have.

So it’s a pretty broad-based set of capabilities that were either providing directly or indirectly in support of the conflict. And as you’ve probably seen, the budget that has been outlaid for Ukraine relief. A minor portion of that is currently on contract. There is still a lot more to be put on contracts. So we see that continuing to flow through this year and next.

Douglas Harned

And one of the things earlier this year that you had said that surprised me was when you said that 10% of your revenues are actually related to missile defense.

Kathy Warden

Yes.

Douglas Harned

Could you help us understand what is in that?

Kathy Warden

Yes. So it’s on scale with B-21. Set in the left 35 [ph], all of which are about 10% of our business. Our Missile Defense portfolio is as well. And yet it’s a collection of many programs, unlike those other that are singular programs of record. It includes works that we’re doing for the Space Development Agency in missile warning and tracking. It includes work that we’re doing for the Space force more broadly in that domain with OPIR. We also are supporting ground-based command and control through the Missile Defense Agency. And we have short-range missile defense solutions like IBCS that we’ve talked about having developed for the U.S. Army.

So the other interesting thing is that, that portfolio extends across many services and agencies as well as many programs. But part of what we do is knit it together to be a full capability set that can be utilized in defensive Guam scenarios, working with Poland to deploy IBCS, and then integrating that into how we think about feeding more information into the sensor suites and command and control. We’re really at the tip of the iceberg on how much runway we have to continue to grow that portfolio of programs. And then, of course, we have the interceptors as well, with next-generation interceptor and glide-phase interceptor.

Douglas Harned

Staying on across the company, but on the other side of this, which is the supply chain issue, which has been something that has affected you in a lot of areas. Can you help us understand where the biggest challenges are right now with respect to supply chain? And what you see is the path to resolution?

Kathy Warden

Our exposure in the supply chain has been very broad-based. It’s not one particular area. If I did have to single out one, the pain point has been more in electronics than any other single area. And yet, what we see is it takes time for disruption in the supply chain that occurred 18, 24 months ago to flow into either our production lines or in many cases, into our development programs that are waiting for first articles that are dependent on some of these lower level parks that have been constrained. And that impact isn’t just the delay of that part, it’s the delay of the program, while it waits for those parts to be delivered. The discovery is largely behind us. A year ago, we were going out for parts that we used to be able to get in a year and believe time had extended to 2 years.

That isn’t happening as much anymore. But to the extent that there was happening a year ago, it is still having ripple effects into those programs and creating some pressure on our margin rates. I do see that dissipating and gradually improving. We talked about that on our first quarter call and reaffirmed that we’re seeing that continue — that progress continue in the second quarter. And we expect that continue to resolve itself into our programs throughout the remainder of this year. And so I think we’ve hit the low point, and now we’re on a positive trend line.

Douglas Harned

Well, when you move on to that positive trend line, is there significant work in process inventory that you just haven’t been able to deliver? And when should we expect kind of a surge as you unwind some of that inventory?

Kathy Warden

We certainly have had to build up a bit more inventory than we normally would in our operations. It’s — for us not significant because, in many cases, it’s the development work where its small quantities of units where we are experiencing this. On our larger production programs, those issues worked themselves out sooner. So F-35, we talked about having some notable parts impact 1.5 years ago, and we worked our way through those during the course of 2022, and that production line is now back to pre-pandemic production intervals. But for programs like Sentinel, where it’s far less quantity, we’re just waiting for a couple of developmental units. Those impacts are still flowing through the supply chain. So I would say that you’re not going to see a big inventory unwind from us just based on the portfolio and the composition, it’s more just putting some incremental pressure on program EACs and margin rates.

Douglas Harned

So B-21. This has been a hot topic for investors ever since you made the disclosure on the 10-K earlier this year that your five LRIP contracts could have a loss. That was described as due to assumptions around inflation. So perhaps you can help us through, I’d say, first, if we go forward and we look at inflation assumptions over the next several years, how are you thinking about this? In other words, what kinds of inflationary conditions might lead to a loss versus if inflation is normalized and everything is fine? How do — how should we all think about this?

Kathy Warden

Right. So the way to think about it is we are working every lever we have to minimize the impact that we saw when we took a forward look late last year on those production lots. And so things that are in our control are learning curves, productivity, labor rates. Of course, they have to be competitive labor rates, so incorporating the impacts of the inflation we’ve seen and our supplier costs. So we are still working all of those dimensions of cost to drive them into a profitable profile for the program. But based on conditions in 2022, projected forward, there was the potential, while not probable because we have all this time to work these mitigants that are in our control, plus we are engaging with the government to address inflation broadly.

And in the FY ’23 budget, the Congress did allocate $1 billion for the department to address just these kinds of issues on contracts related to inflationary pressures. So there are a series of steps that we’re taking to mitigate the risk that we outlined. We always want to be very transparent. So that range was $0billion to $1.2 billion. And if it were viewed as probable, we obviously would have taken it. We have plenty of time to work these mitigants.

I would also say that LRIP is a small portion of the economic value on the B-21 program. And it is quite unique in our portfolio at least to have a program that had that long of a duration. Most of our contracts, we have the opportunity to reprice on an annual basis. And so we can absorb, for a short period of time, inflationary pressures and then price them in. The B-21 does not have that feature, but that uniqueness also allows it to stand out as the government thinks about how should this be handled? And what is the right risk sharing approach?

Douglas Harned

But I mean my understanding is that later this year, you will finalize things on the first LRIP.

Kathy Warden

Right.

Douglas Harned

And in doing that, is that when you would also discuss the potential for equitable price adjustments? And we might start to get a sense of how the Pentagon is going to approach this?

Kathy Warden

That is when we would expect to have quantification around what the government might provide us in relief, yes, if anything.

Douglas Harned

Okay. Yes. And so when you think of this in term — in the broader context of Aeronautics, I mean, of course, should you end up with something in that $0 billion to $1.2 billion negative range over — it’s over about 5 years, I think?

Kathy Warden

Yes, more than 5.

Douglas Harned

Yes. So if you ended up with that, how do you think about Aeronautics margins over the next 5 years?

Kathy Warden

We covered this in some detail on our call to outline why we believe AS margins can stay in the 10% range. And it’s basically taking about 60% of the portfolio that is mature production programs that operate in the 12% to 13% margin range as most production contracts in the industry do. And then, looking at the other 40% of the portfolio being a mix of the LRIP lots, some continued development on B-21, modernization on B-21 and some other early stage development. And that basket of 40% or so of our revenues being in the mid-single-digit range, and the netting of that gets you to about 10%.

And those assumptions are very much in line with what we’ve articulated on B-21, but also our experience with a portfolio mix that we have and expect to have over the next several years. So we think it’s very realistic that we would continue around this 10% operating margin even if we had zero profit coming from the LRIP lots.

Douglas Harned

Okay. Then perhaps you can just also fill us in on how the program is doing as much as you can say as we head towards first flight?

Kathy Warden

Yes. The program is progressing very well. Both the Air Force and Northrop Grumman are so proud of the work our teams have done together to deliver this capability on the schedule the government needed and targeting toward a price below their key performance factor for target price. So this is really, in my mind and Air Force leaders have spoken about it, as a model program. And we’re proud to have been a part of it working alongside the Air Force. We are working towards first flight, which, as the Air Force has been clear, will be based on data. And we will fly it when they deem it is safe to do so, but that is tracking toward a milestone this year. And as you said, the next big milestone then will be to get Lot 1 on contract, although we’re already working early production activities in support of that ramp.

Douglas Harned

Within Aeronautics, there’s obviously another big program, the Next-Generation Air Dominance or NGAD. Can you — and now that the Air Force has sort of formally launched this competition. Can you talk about how you see the company positioned for this?

Kathy Warden

Right. So I’m not at liberty to say much about the program itself, but the company is well positioned to perform on these advanced aircraft. And we’ve demonstrated that on the B-21. And we think about a series of opportunities that are upcoming, both for manned and unmanned aircraft. And what we have worked to do is identify where we want to place our bets and ensure that we are adequately resourced to perform. And both from a platform perspective as well as emission systems provider, because often when these opportunities come about, we talk about it only through the Aeronautics lens. But I’ll remind you, our Mission Systems portfolio is also a key enabler on manned and unmanned platforms and are two involved in programs like this. So we will make determinations on where we decide to pursue and not around a basket of opportunities, this being one of them.

Douglas Harned

Aeronautics as a whole, I mean one of the challenges you’ve had has been a number of mature programs that have kind of come down, while B-21 is kind of coming up in there. Can you give us a sense of how we should think about the revenue trajectory now given that mix over the next few years?

Kathy Warden

Right, we’ve been consistent. We expect Aeronautics to return to growth in 2024. And that’s because of a few factors, you noted B-21 and the growth on B-21. That will be somewhat modest in ’24. And then as production ramps, we’ll continue to accelerate. We have mature programs like E-2D and F-35, pretty stable, modest growth again. And then we’ve had some headwinds, programs like Joint STARS and Global Hawk retiring. And those have been the key driver of declines in the Aeronautic portfolio for the last couple of years. Those are largely behind us when you look at a year-over-year basis. So we’ve completed those programs. They’ve moved into modest sustainment. And so those headwinds being behind us now provide the platform for that B-21 growth to come through the Aeronautics top line and support a growth story starting in 2024.

Douglas Harned

So if I go back a few years, when you just become CEO, I remember we had a conversation. You said a priority for me is building a missiles business, becoming really the third major U.S. missile supplier. And I remember, I expressed some skepticism by the time you do that, how do you know there will be any demand for missiles? I thought I was right like 1.5 years ago, but right now, it looks like you’re right. So could you tell us about how you are building this missiles business and where you want to go with it?

Kathy Warden

Yes. So I’d like to take credit for being clairvoyant. But of course, we just were looking to extend the diversification of our portfolio and wanted to have more exposure and expendables. So it was a key part of our acquisition baseline case for Orbital ATK. And we then wanted to realize those revenue synergies that we had assumed. I will say we blew through those revenue synergies in space very shortly into the deal, but we continued on the path to expand our weapons portfolio. And the last 1.5 years, that demand really has materialized in the munition space as well. We are clear-eyed though. This is not about priming in that space as much as it is about being a key supplier and expanding our reach. And so that’s where you see the investments that we’ve made in solid rocket motors. And I took some time on our first quarter call to outline what those investments are, where we’ve spent, what that has meant in terms of our ability to have capacity now as that demand is materializing.

And so we see our munitions business growing. We see our missiles portfolio growing, but largely the growth is coming as the supplier of propulsion systems on both conventional weapons, like GMLRS, where we have a great partnership with Lockheed Martin. On hypersonics platforms like HACM, where we have a terrific partnership with Raytheon. And we see growth in all of those dimensions as a key enabling supplier.

Douglas Harned

There are a couple of questions on here, too, about this. And just to the point where Aerojet Rocketdyne has had some issues on the rocket motor side, and that’s — there have been public comments about that. How are you thinking about further investment here? As you were saying, it seems like you kind of got ahead of this a little bit in terms of demand. Have you had many issues, I’d say, supplier issues, the kinds of things that appear to have affected your competitor?

Kathy Warden

We have not seen a constraint in building up our SRM capacity — solid rocket motor capacity. And that’s largely because we have that expertise in-house, and we were able to execute on those plans. And we had laid in the capital to do so. And those investments now are largely in the rearview mirror, to the extent where we have the capacity to not only support ramp on the programs we were on, but we are being asked to be second source or even take more of the capacity required in the near term because we had laid that investment in and can support the capacity.

There’s enough growth when you look at what’s laid into the U.S. [indiscernible] and when you think about the international demand, particularly from our European allies that we believe the capacity we’ve laid in will have strong demand signal through the remainder of the decade, if not beyond, and that we will have gotten our return on that investment just based on what we see in the next 5-year period. We have facilitized to a point where we meet a portion of the demand, but not all of the surge. So there’s still plenty of room for Aerojet Rocketdyne in the equation as well. And for the government to decide whether they want to through Defense Production Act funds, fund some surge capacity, which I think is a really smart idea.

But we aren’t going to get — we aren’t going to facilitize to a surge rate because we don’t see that as a long-term sustaining demand. And we’ve been pretty candid with the government as to what that looks like and giving them the information to make those trades. But I wouldn’t be surprised to see if more funding comes through the Defense Production Act.

Douglas Harned

Have you got — I mean, Aerojet Rocketdyne got this money for Defense Production Act. Have you all gotten the same?

Kathy Warden

They did. Right. Not yet. But we have proposals and that’s — they’re evaluating. I think there was some more urgency around Aerojet because they had not done the investment we have done; so that’s to drive a little bit more parity there. But as we look at surge capacity, I think we’re in the equation.

Douglas Harned

Okay. Can you give us an update on Sentinel or GBSD?

Kathy Warden

Yes. Sentinel is also progressing well. We are earlier in the stage of development there, but we’ve had some important key milestones. We did static motor testing in the first quarter successfully. We also have been doing a good bit of wind tunnel testing, all of which are proving out the design for the missile system itself. And we are doing significant risk reduction on the launch facility modifications at our facility in promontory so that when we get to the construction scope of the program, we have worked out those processes and reduced the risk associated with that construction scope. So all tremendous progress in what has been a difficult environment for these early-stage development programs.

We are now at a point where the program is reaching its staffing requirements, and we are working with the government to lay out an approach to meet IOC, initial operating capability, even given some of the challenges that we have faced. And so it’s all hands on deck. This program is one of the largest and most complex, both the Department of Defense and our company has underway. And so it’s a high priority for us. And I’m really pleased with how the team is stepping up, and we’re using many of the same processes that we successfully used on the B-21 in terms of active contract management, both between the government and Northrop Grumman. So I’m confident.

Douglas Harned

What’s the latest on like when IOC is being targeted?

Kathy Warden

Yes. So IOC for this program is targeted in 2029, and we are working with the government on what the path to achieve that objective will look like, given that some things we’ve been able to pull to the left, other things sliding to the right and so just working on clear new baseline for achieving that IOC; and there is great urgency. As I said, each of the three modernization efforts underway with the triad or there’s not scheduled reserve. The government got started later on each one of them for different reasons than they had initially intended, and so schedule is paramount. And that’s what we are focused on with the government.

The good news there is it’s a different risk sharing model, which allows us to work much more seamlessly because it’s cost plus. And so we’re able to apply resources as needed to retire risks and move more quickly in that environment.

Douglas Harned

Yes. And that’s something I wanted to see if we can understand a little more on. When you look at — if IOC, is about 2029 and you’re looking at the progression of your cost-plus work, presumably, that will transition over to some fixed price work at some point. Like how does that kind of layer in sort of to LRIP and full rate production?

Kathy Warden

Right. So those production lots will be priced at a later point when we have a more mature design that the government has agreed on so that we can minimize change to those requirements and change to the design. And so what we’re pricing has higher level of fidelity and a lower level of risk to all involved. So I think this is a much better way for programs like this that extend over a long period of time to be done. And we will move to fixed price at the right time on this program. We’re committed to that. We are also committed to meeting the cost objectives on this program. And just like we have on B-21, but the difference will be, we’ll have a more mature design when we’re setting that pricing.

Douglas Harned

So just so I can clarify. So unlike the B-21, where you essentially signed up for a unit price, for LRIP in 2015, for this, you’re really looking at it as we’ll do the development, and then you’ll have a new contract that will be priced for LRIP?

Kathy Warden

That’s right.

Douglas Harned

Yes. Okay. And then how should we think about the revenue path of, say, over the next 5 years? What will this look like?

Kathy Warden

Yes. So for the GBSD or Sentinel program, as it’s now referred, we have been growing that program about $500 million of growth in the program this year. And that will continue in 2024 before it hits max rate on the development program around 2025, but then we expect production long — lead to very quickly thereafter. So I think in the ’26 time frame and production to ramp through the remainder of the decade and well into the early 2030s. And that growth that we’ll see in the later part of the decade is actually a much steeper growth curve is we’re not only producing the missiles, but we’re doing all the construction scope associated with the launch facilities themselves.

Douglas Harned

And then this is in Space, but elsewhere in Space. Space is your fastest-growing area. We’ve seen 20% plus type increases in the defense budget kind of year after year for the last few years. If I were to look at just the ex-GBSD portion of your space business, what kind of growth are you looking at there?

Kathy Warden

It’s been about half of the growth. So it would take Sentinel accounting for 1/2, and then the rest of the space growth is coming from a broad set of program areas. Of course, National Security Space has been first among them in terms of contributing to the growth rate, and that’s recapitalization of ISR sensors, communication, missile defense. I outlined a few of those in the earlier discussion on missile defense. And then our NASA portfolio has also been growing nicely as we are supporting the Artemis program, and NASA’s Return to The Moon. So it is really a broad-based growth story in our Space portfolio.

Douglas Harned

And I guess within that, one of the things — and you and I have talked about this before, this sort of transition where you’ve got a pretty large role now in — a lot of it is classified, but in low-Earth orbit constellations. And the nature of the work will change over time. In fact, we — with Chris Kubasik, before we talked about this one too. Can you talk about how you see the difference from what I would call the — it’s hard to call it the old days of things like CBERS and where you’re doing $1 billion satellites, small constellations, how is your work going to be different going forward with these large LEO constellations?

Kathy Warden

So clearly, lower price point on a per unit basis, but much higher quantity and what that drives is some production efficiency when you’re producing at rate. So that will be supported — supportive of those lower cost points, but it also should give us the opportunity to drive margin through learning curve and productivity as we do more in the aircraft world where we see these kinds of quantities in the dozens, if not, in some cases with LEO constellations of 100 more satellites.

What I would say is that, I don’t see this as an either/or. And when we talk to customers, it’s not — we’re going to move everything to LEO. There certainly is a push to drive as much as it can be to constellations in LEO that are lower price point and have the resiliency of proliferation. But at the same time, there are physics involved. And so there are some things that are better done from other orbits and that require more sophisticated payloads. So this isn’t a move away completely from those more sophisticated capabilities that you spoke of. It’s going to be a balance in our future architecture.

Douglas Harned

And then, I was talking about growth rates of — in the budget of like 20 — 20-plus percent, I don’t think you want any of us to be modeling 20-plus percent annual growth every year. How should we think about growth?

Kathy Warden

So in Space, we have, as Doug is referencing, had 20% growth within last year about 16%. First quarter of this year 17%. So we have really liked these rates of growth. But when I talk about Sentinel starting to flatten out in terms of year-over-year growth and many of the areas that are contributing to growth on the space side be new programs that have gotten started, we don’t expect to see 20% growth. But what we are guiding this year is at least 10. And so we’re still in double-digit territory, but we do see a slight moderation on Space growth. I would also say we look at it over a long term. So in any given year, you are going to see some modest fluctuations. But when we look at the decade, we see tremendous growth.

We’ve already seen our space business nearly double in the last 3 years. And when we look out over the decade with that ramp I talked about in Sentinel, if we are successful in a down select our next-generation intercept or in glide-phase interceptor, if we continue to be successful with this Space Development Agency in both their transport and tracking layers, I mean, there is just tremendous growth opportunity for our space portfolio still ahead of us through this decade.

Douglas Harned

The margins in the Space have been under a little pressure lately. Presumably, some of that’s due to mix, but perhaps you can comment on how much is mix? How much might be supply chain or other issues?

Kathy Warden

It’s a combination. We had talked about mix pressures in the Space business and that margins would compress in that business and that that would continue for a couple of years as we absorb Sentinel, as we absorbed the growth in the other part of the portfolio. It has been exacerbated by the disruption that we’ve seen in supply chain and inflation and the pressure that’s put into program EACs. But I would say it is more mixed than it is those temporal disruptions. And we see both of those now starting to no longer be headwinds. They don’t really turn to tailwinds until we get the supply chain disruption behind us and I told you we’re starting to see that ease.

And until we move some of these big programs toward production, but that’s within our sights now. So we definitely see the potential for a shift in margins in Space. It’s not this year, it’s likely not significant next year. But as we look to 2025 and beyond, we see our greatest margin expansion opportunity in Space because of that mix shift.

Douglas Harned

Now Mission Systems, it doesn’t seem to get as much attention from a lot of investors, but you’ve talked about it before as your second fastest-growing business.

Kathy Warden

Right.

Douglas Harned

But we haven’t seen a lot of growth, including in the backlog. Can you talk about that and how you expect it to grow from here?

Kathy Warden

For Mission Systems, it’s a workhorse in the portfolio from many dimensions. It is our highest margin business. It is our second fastest growing. So from an economic value creation, it is a really strong contributor. But it also is a technology hotbed, and it is feeding capability into our Space business, into our Aeronautics business and into our Defense Weapons business. And as a result, it’s creating innovation that leads to these larger wins like a Sentinel. And so that gets underestimated because that growth is captured in the other segments. But it is absolutely enabled by a strong Mission Systems portfolio that has heavy customer-funded research and development that drives technology advancement, that makes these capabilities technically differentiated in our Space, our Aeronautics and our Defense businesses. So it’s a bit of a misnomer to think of the contribution to the company’s value for Mission Systems by solely looking at that portfolio’s P&L.

Douglas Harned

Well, and this has been kind of a — I mean, it’s been a good margin business, I mean, 15%, 16% type margin business. Is that how we should think of it? Or is there potential for margin expansion there?

Kathy Warden

There may be some modest opportunity, but 15% margins are pretty good in this business, right? So I look more at how do we extract the value out of those already high-margin product lines into growth at decent margins as a prime that is creating more than — more impact than winning another radar in Mission Systems, right? And so that’s how we think about balancing the resources and focus of that team. And I think that has allowed us to create more economic value across the portfolio than just looking at maximizing margin rates within the MS portfolio itself. I think it’s operating pretty much at a level I see as top performance.

Douglas Harned

Well, your international exposure is less than some of the other big primes, about 13% of revenues. So when you look forward, you’re clearly getting some benefits from — related to the conflict in Ukraine. Should we expect that to grow higher? I mean obviously, you benefit from growth on the U.S. side. So how do you expect international to grow compared to your U.S. business?

Kathy Warden

So our international business has been growing approximately in line with our U.S. business. We do see the opportunity for the international growth to accelerate, albeit off of a smaller base, so it’s not going to contribute on a dollar basis to the same extent that our domestic growth will. But we — because of the portfolio and how it relates to where we see increased demand globally in Missile, Defense and Munitions, we see it growing at a faster rate on a go-forward basis than it has the last several years, to the point where we do expect it will have a double-digit CAGR over the next several years as things like our F-16 radars or F-35 continue to have strong international demand. And now we’re layering on top of that Missile Defense — Missiles and Munitions.

Douglas Harned

And then on some new technologies, like Hypersonics, who’s — directed energy. There’s a whole number of things that are priorities now. Can you talk about how you all are pursuing those?

Kathy Warden

Right. So with Hypersonics, we think of the market in two ways: one, defending against offensive hypersonic weapon. And I talked about our Missile Defense portfolio, which is inclusive of detecting and intercepting hypersonic vehicles. And then, on the weapon side itself more as a propulsion provider. So I talked about the partnership we have with Raytheon on HACM. I have alluded to what we’re doing on conventional prompt strike and LRHW. These are programs where we are a key supporting supplier, and we see hypersonic weapons being an area of importance.

And we are scaling up in an Elkton, Maryland facility, the ability to continue that design work and ramp production. But it’s not going to replace conventional weapons again. So we have a balanced perspective on what that portfolio will generate and where we’re placing investment there and how quickly that market will materialize to actually see our more conventional weapons, accelerating growth faster in the near term than hypersonics, but we’re well positioned to cover the basis.

Douglas Harned

And Directed Energy, is that…

Kathy Warden

Yes. We’ve made selective investments in Directed Energy. Over time, I don’t see that being a big value creator for us in the near term, and we continue to do some work and experimentation and demonstrations in that area.

Douglas Harned

I guess if we can roll this all together. And when you look at the next 5 years, can you give us a sense of what kind of top line growth rate we should be expecting?

Kathy Warden

Well, I’m going to stop short of giving you long-range guidance as you would expect, Doug. But what I will say is I’ve given you piece parts that reflect a real optimism of how our portfolio supports the U.S. National Defense strategy, the NASA space exploration strategy and international demand, such that I am bullish on our company’s growth. And it’s not based on programs we need to go win necessarily, it’s solid execution on backlog we have in hand that supports above-market growth. I also feel confident as I look at the strategy and the budget alignment that we’ve seen in recent years, meaning the appropriations are really reflecting what is outlined in the National Defense strategy, that our portfolio is very well aligned such that, that support should continue given this threat environment that we find ourselves in.

And I find it difficult to think that we are going to view that threat environment differently in either the near or midterm. There are just too many actions and events that are occurring regularly that make me more concerned about the security environment and the escalation and therefore, the capabilities we need to deter and defend.

Douglas Harned

And then can you remind us of your thinking on free cash flow growth over the next few years? And basically, cash deployment?

Kathy Warden

Yes. That too is a really exciting part of our story because when you talk about the outlook we’ve provided, being greater than 20% compound annual growth through the 2025 period, which is what we have provided in the outlook, the real story continues through 2025 and the rest of the decade. There are a number of factors contributing to that. Some nonoperational cash taxes, clearly with Section 174 that headwind that we have decreases by $200 million each year. We have had some CAS pension headwinds that are now behind us in terms of our free cash flow. And we also see our CapEx as decisionable, but something we have committed to continue to keep at an elevated level through 2024, but then start to really drive down starting in 2025. And then you layer on top of that the operational growth that I spoke about and the translation through higher margin rates and to even more earnings and cash ’25 through ’30 look really strong for our company’s cash generation and deployment.

Douglas Harned

So I guess to wrap up here, maybe you could tell us what are the two or three things that you’re going to be focusing your time on over the next 12 months?

Kathy Warden

Yes. For me and the entire Northrop Grumman leadership team, it’s about executing on our commitments, both to shareholders and customers. We feel that’s the strong foundation for this continued growth as well as the margin expansion and cash generation that I spoke of. We also are focused on smart capital deployment. So I don’t take it lightly that we’re investing 7.5% of our revenue in R&D and CapEx. We are doing that because we see a clear path to getting return on that investment and translating it into growth. We’re serious about making that happen. And so that is a key focus for us, and that’s about placing the right bets in technologies.

And I think what we did in munitions that we outlined is a great example of seeing demand coming, getting ahead of lane and capacitization that’s allowing us to position for share. But there are many technology areas where we’re doing that as well that are leading to our outsized positioning competitively in Aeronautics, Space and Mission Systems, in particular. And so getting all four of the businesses return to growth in 2024, which is our expectation, that DS and AS will be back on a growth trajectory. MS will stay on one and Space will continue to be there as well, creates that opportunity for us to really expand value creation, and that’s what we’re going to do.

Douglas Harned

Okay. Well, great. Well, thank you very much, Kathy, for joining us today.

Kathy Warden

Thank you.

Question-and-Answer Session

End of Q&A