Stephen C. Movius - Corporate Vice President and Treasurer, Vice President Investor Relations Wesley G. Bush - Chairman, President & Chief Executive Officer Kenneth L. Bedingfield - Chief Financial Officer & Corporate Vice President.

Myles Alexander Walton - Deutsche Bank Securities, Inc. Richard T. Safran - The Buckingham Research Group, Inc. George D. Shapiro - Shapiro Research LLC Samuel J. Pearlstein - Wells Fargo Securities LLC Noah Poponak - Goldman Sachs & Co. Doug Stuart Harned - Sanford C. Bernstein & Co. LLC Joseph DeNardi - Stifel, Nicolaus & Co., Inc. Jason M.

Gursky - Citigroup Global Markets, Inc. (Broker) Carter Copeland - Barclays Capital, Inc. Howard Alan Rubel - Jefferies LLC Cai von Rumohr - Cowen & Co. LLC Seth M. Seifman - JPMorgan Securities LLC Hunter K. Keay - Wolfe Research LLC Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker).

Good day, ladies and gentlemen. And welcome to the Northrop Grumman's Second Quarter 2016 Conference Call. Today's call is being recorded. My name is Robin and I will be your operator today. At this time, all participants are in a listen-only mode. I would now like to turn the call over to our host, Mr.

Steve Movius, Treasurer and Vice President, Investor Relations. Mr. Movius, please proceed..

Thanks, Robin, and welcome to Northrop Grumman's second quarter 2016 conference call. Before we start, please understand the matters discussed on today's call constitute forward-looking statements pursuant to Safe Harbor provisions of Federal Securities laws.

Forward-looking statements involve risks and uncertainties, which are detailed in today's press release and our SEC filings. These risk factors may cause actual company results to differ materially. Matters discussed on today's call may also include non-GAAP financial measures that are reconciled in the earnings release.

I would also note that after the conclusion of today's call, we will be posting an updated Northrop Grumman overview to the Investor Relations page of our website. The overview includes detailed information on each of our three sectors. On the call today is our Chairman, CEO and President, Wes Bush; and Ken Bedingfield, our CFO.

At this time, I'd like to turn the call over to Wes..

All right, thanks, Steve. Good afternoon, everyone, and thanks for joining us. We had a very strong second quarter, driven by solid operational execution and effective cash deployment. I want to thank our team for their unwavering focus on performance.

Second quarter sales totaled $6 billion, 2% higher than last year's second quarter, driven by growth at both Aerospace Systems and Mission Systems. At Aerospace Systems, we're reaching an inflection point, where new programs and the planned ramp-ups on production programs are beginning to outpace declines on mature legacy programs.

While we may see some variability in that trend going forward, the growth in manned and autonomous systems drove a 4% second quarter sales increase. The programs driving sales include our restricted programs, the production ramp-up on F-35 Triton and volume in Global Hawk, as we began production for international customers.

These growing programs are more than offsetting the expected declines in AS programs such as NATO AGS, F/A-18, Advanced EHF and the James Webb Space Telescope. Sales at Mission Systems grew in the second quarter, driven by higher volume for restricted programs and ramp-ups on programs like F-35, G/ATOR, SEWIP Block III, JCREW and (2:51).

We delivered our first (2:53) Systems in June and we expect this program to continue ramping up. The reorganization at Technology Services at the beginning of this year has enabled us to sharpen our focus on reshaping its portfolio to better align with our strategy of providing differentiated services and capabilities in this market space.

We see this as an important business for our company. And while these portfolio actions may impact sales growth at TS in the near-term, we see this restructuring process as key to aligning our investments and capabilities at TS with our longer-term growth objectives for this business.

Enterprise-wide, as we continue to add new programs and shape our portfolio, we remain focused on sustaining strong performance and operational excellence. This focus enabled all three of our businesses to contribute to a solid 12.2% segment operating margin rate in the second quarter and a 12% rate year-to-date.

Second quarter EPS increased 4% to $2.85. And based on our year-to-date results and a tax benefit that we will record in the third quarter, we are increasing 2016 EPS guidance to a range of $10.75 to $11 versus our prior guidance of $10.40 to $10.70.

Second quarter cash from operations was approximately $600 million, consistent with last year's second quarter. Capital expenditures totaled $173 million and free cash flow totaled $431 million. As we've mentioned on previous calls, our capital spending plans contemplate the purchase of several buildings this year.

And during the first half of the year, we implemented those plans, with facilities purchases totaling approximately $240 million. This includes a facility purchased for $80 million in the second quarter.

At the midpoint of the year, capital spending was $471 million and we now expect our 2016 capital spending will range between $800 million and $1 billion. We continue to expect free cash flow of $1.5 billion to $1.8 billion. In addition to investing in our businesses, we continue to return cash to shareholders.

In May, we increased our quarterly dividend 12.5% to an annual rate of $3.60, our 13th consecutive annual dividend increase, and our fifth consecutive double-digit increase. We also continue to repurchase our shares. During the quarter, we bought back 1.9 million shares, bringing year-to-date repurchases to 3.4 million shares.

At the end of the second quarter, approximately $3.6 billion remained on our share repurchase authorization. We do not yet have an FY 2017 Defense Appropriations Bill. And as Congress has adjourned until September, it is increasingly likely that we will begin the government's fiscal year 2017 with a Continuing Resolution.

As you know, a CR will constrain our customers' ability to achieve planned program ramp-ups and to start new programs. Beginning the new fiscal year with a CR has unfortunately become a familiar scenario. The larger concern is how long the CR lasts. Obviously, the longer a CR lasts, the more disruptive it is to our customers' acquisitions plans.

So, we encourage Congress to work together to fund our government and enable its effective operations. In summary, we're pleased with our year-to-date results. And we expect our focus on performance to continue to generate solid results for the remainder of 2016, as demonstrated by our updated guidance.

We remain well-positioned to achieve profitable long term growth, and we continue to generate value through performance, managing our portfolio and our approach to cash deployment. So, now, I'll turn the call over to Ken for a more detailed discussion of our results and our guidance.

Ken?.

Thanks, Wes, and good afternoon, everyone. I want to add my congratulations to the team on our second quarter performance. Today, I'll briefly review second quarter results and provide a bit more detail on our 2016 guidance. It was a good quarter, with higher sales and EPS, and strong margin rates and cash flow.

Performance was strong at all three sectors. Aerospace Systems sales rose 4% in both the quarter and year-to-date periods.

Increases in both periods reflect higher volume on manned aircraft programs and autonomous systems, which more than offset a low single-digit decline in space volume due to lower non-restricted activity on programs like AEHF and the James Webb Space Telescope.

Restricted activities and higher F-35 deliveries were the growth drivers in manned aircraft. Growth in these areas more than offset lower volume for the F/A-18 and B-2 programs. The F/A-18 continues to ramp down. We delivered five units this quarter versus eight units in last year's second quarter.

Lower volume on the B-2 is due to timing of modernization activities. In autonomous systems, volume continues to ramp up on Triton and Global Hawk, more than offsetting lower activity on other autonomous programs, primarily NATO AGS.

While space sales were lower, volume for restricted activities grew, but did not fully offset lower volume for the non-restricted space programs I referenced earlier. Aerospace Systems' operating income declined slightly. Change in contract mix and a timing of risk retirements more than offset the impact of higher sales.

Operating margin rate was 12% versus 12.8% in the last year's second quarter. And most of you will recall that last year's results benefited from risk retirements on a restricted program. At the midpoint of the year, Aerospace is on track to achieve our sales guidance in the low $10 billion range.

Through six months, Aerospace has an operating margin rate of 11.6% and we continue to expect AS to generate a margin rate in the mid to high 11% range, no change from prior guidance. Mission Systems second quarter sales grew more than 2% and year-to-date MS sales are up 1%.

Both periods reflect higher sales volume for Advanced Capabilities programs, as well as Sensors and Processing programs. The primary drivers in Advanced Capabilities are restricted programs and ramp-up on several navigation and maritime programs, including SEWIP Block III.

Ramp-up on G/ATOR contributed to higher Sensors and Processing volume in both periods and JCREW contributed to the second quarter increase. Mission Systems second quarter operating income increased 1% and operating margin rate was 13%. Year-to-date MS operating income is up 2%, with an operating margin rate of 13.1%.

Based on year-to-date results, we continue to expect Mission Systems sales in the high $10 billion range, unchanged from prior guidance. And based on strong year-to-date results, we are increasing our guidance for operating margin rate to the high 12% range versus our prior guidance of a mid-to-high 12%.

Technology Services second quarter sales declined 2% and year-to-date sales are down 3%. The trend for both periods reflects the completion of several programs in 2015, lower ICBM volume as well as the ongoing repositioning of the business portfolio, as mentioned by Wes.

Second quarter operating income increased 2% and operating margin rate expanded 50 basis points to 10.8% due to improved performance. Year-to-date, TS operating margin rate has expanded 20 basis points to 10.6%, and we are raising our margin guidance to low 10% from our prior guidance of approximately 10%.

We continue to expect TS sales in the mid-$4 billion range. Total segment operating margin was 12.2% for the quarter and 12% year-to-date. We continue to expect a high 11% segment margin rate for the year. Total operating margin rate was 13.3% for the second quarter and 12.8% year-to-date.

We now expect a low 12% total operating margin rate for the year versus our prior guidance of approximately 12%. Our updated guidance assumes unallocated corporate expenses of $175 million, lower than our prior estimate of approximately $200 million.

You'll recall that our unallocated corporate expense is typically more heavily weighted toward the second half of the year, with the fourth quarter generally being the highest. We expect that to be the case again this year. Our guidance also includes net FAS/CAS pension adjustment of $275 million.

Keep in mind that we will be finalizing our 2016 pension demographic study in the third quarter. The study results may impact our net FAS/CAS pension adjustment for 2016, so no change to the guidance until that is finalized. Wes mentioned one of the drivers of our EPS guidance increase is a tax benefit we will record in the third quarter.

After the close of the second quarter, we received approval from the Congressional Joint Committee on Taxation for the resolution of the IRS examination of our 2007 to 2011 tax returns. As a result, our third quarter 2016 income tax expense will be reduced by approximately $40 million.

This will reduce our 2016 expected effective tax rate to approximately 25.5% and provide approximately $0.20 more in EPS. All that rolls up to our increased 2016 EPS guidance of $10.75 to $11, which continues to assume our weighted average diluted shares decline by approximately 6% to 181 million shares.

We continue to expect 2016 free cash flow will range between $1.5 billion and $1.8 billion. Our free cash flow guidance now anticipates capital spending of $800 million to $1 billion in 2016 versus our prior guidance of $700 million to $1 billion.

A quick update on backlog, as we indicated last quarter, we intend to report backlog for the full year and provide trend information each quarter. Year-to-date, our backlog has increased and reflects higher backlog at Aerospace, a modest decline in backlog at Mission Systems and a high single-digit decline at Technology Services.

Looking ahead to next year, and in light of the significant decline in interest rates through mid-year, I thought it would be helpful to remind everyone of our discount rate and plan asset returns sensitivities as they may impact our 2017 FAS expense.

Every 25 basis point change in our discount rate results in a net impact of approximately $70 million to our 2017 FAS expense. And every 100 basis point difference in our 8% return assumption and actual plan return changes 2017 FAS by approximately $50 million.

In January, we provided a $470 million estimate for 2017 FAS based on a 4.53% discount rate and plan asset returns of 8%. Year-to-date plan asset returns are a bit north of 6%. And as you're all aware, benchmark interest rates have declined by about 75 basis points.

If we had to set our discount rate today and holding all other assumptions constant, our expected 2017 FAS expense would be about $200 million higher, or $670 million. But obviously, a lot can happen between now and year-end.

We continue to expect CAS expense of approximately $1 billion for 2017, and we continue to expect 2017 and 2018 required cash contributions will remain fairly low at about $100 million each year. I don't expect much volatility in these required pension contributions, barring major market disruptions.

One final note on Brexit, while it's too early to predict any long-term impacts Brexit may have on our business, we saw no material impact to second quarter results. We have limited foreign currency exposures related to the affected currencies and we had significant contract-related exposure.

We did see a decrement in our reported cash balances in U.S. dollars of about $30 million, which reflects the conversion of balances held in affected foreign currencies. With that, I think we're ready for Q&A. I'll turn it back over to Steve..

Thanks, Ken. As we open up the call for Q&A, we ask each participant to ask a single question, and please rejoin the queue if you have a following question.

Robin, if you could open up the line?.

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

Thanks, good afternoon, guys..

Hey, Myles..

Myles, how are you?.

I was hoping to talk a little bit about cash for a second. Lockheed brought up on their call the F-35 lack of contracts under signature being a headwind to ongoing funding of, obviously, their suppliers and their work to make sure everything stays on schedule.

Is there a similar kind of cash drag that you're experiencing now? Can you size it, and is it any risk to full year cash flow?.

Hey, Myles, thanks for the question. In terms of our cash on F-35, our profile is a little bit different than Lockheed's, as they're prime and we're sub. We are on progress payments today as we perform on our work that's in the flow today. And as we get on contract on LRIPs 9 and 10, we will move to performance-based payments.

That will liquidate some of the withhold that we see, primarily at the AS sector in terms of cash flow, but we fully expect that we'll get that resolved, and should see that sort itself out by the end of the year..

Okay. Thank you..

Your next question is from the line of Richard Safran from Buckingham Research..

Wes, Ken, Steve, good afternoon..

Good afternoon..

So, I just have a quick question here on Technology Services. You say, if I got my math right, you saw a 50 basis points higher margins on slightly lower sales. The only comment you made was improved performance. So, I thought, I wanted to ask if you could discuss the quarter in a bit more detail and maybe longer term expectations.

Near-term, are you seeing a better mix of more favorable contracts? Thinking more longer-term, are business conditions improving overall? Are you seeing more favorable contract terms, or is the margin improvement mostly just due to restructuring and taking out cost?.

So, I'll start on that. This is Wes. And let me then turn to Ken to perhaps give a little bit more color on some of the aspects. Overall, when we say performance is the primary driver, that's actually what we mean. TS has a rather significant mix of different contracts across its portfolio.

And credit to the team, they've been doing a really good job on executing on those contracts.

So, it's a broad reflection of the work that's being done across the organization, just to continue to drive on program execution, particularly, I would say, in the global logistics and modernization part of the portfolio, where we're seeing some especially good program performance.

I mentioned in my earlier remarks that we are working on portfolio in TS.

The reorganization that we did at beginning of the year has allowed us to really pull together the broad set of our service and modernization-oriented activities, and kind of step back and look at that market space and ask ourselves how we really want to position to compete over the long-term.

And so we're going through some thinking on which of those areas we're going to continue to invest in and others that we may tune down on as we go forward.

And as I mentioned in remarks, any time we go through a little portfolio tuning, that can in the near-term impact the growth trajectory, but over the long-term, we see this as a very good business for our company, one that we are absolutely committed to being into, and the idea is to make sure that we're investing in the places where we see really differentiated capabilities.

And with differentiated capabilities, we're able to focus on the areas that provide the better margin rates. And that's our strategy as sort of stated in a broad context, but we're looking at that, the implications of that strategy, in each of the three parts of the TS business.

So, it's not just one of the components of that business that are the focus of this activity. And it's enabling us, I think, to better position the organization for longer-term growth.

Ken, anything do you'd want to add to that?.

Yeah. Let me just add that I would say, I agree it's a matter of TS having a broad portfolio of contracts, that are generally differentiated in the types of services we offer, and just real good execution by the team this quarter. There was really no major program or no major area that drove the majority of the increase.

All of the sectors are innovative teams that work really hard to deliver, and they've shown that they can do that this quarter. And, I would just say that maybe another piece of it kind of broadly is disciplined bidding behavior and making sure that we're going after the right work that can deliver the right margins as we look forward.

So, I think that's an important piece of it as well..

Well, thanks very much..

Thanks, Rich..

Your next question is from the line of George Shapiro with Shapiro Research..

Yes..

Hey, George..

Good morning..

Hi, George..

I was looking at, Ken, your guidance for Aero Systems at low $10 billion range in the context of, Wes, your comment that this quarter is the first quarter you've started to see new programs outpace the legacy programs.

So, why wouldn't the subsequent quarters have higher sales and why wouldn't the low $10 billion guidance be somewhat low for the year?.

George, I would say that halfway through the year, we're a bit shy of $5.2 billion in sales. We've got programs that are ramping in terms of volume and programs that are declining. We mentioned F/A-18, AHF (sic) [AEHF] (22:51), and James Webb on the declining side.

So, as we look at the profile, I think we don't generally see significant fluctuations quarter-to-quarter. We don't tend to see a big fourth quarter like some of the other participants in the industry.

And, I think the other impact we're looking at is a fewer number of working days in the fourth quarter of 2016, which is driving kind of a fewer number of second half versus first half days in the year based on our quarterly accounting conventions.

So, overall, I would say that we see certainly a solid path to the low-$10 billion range and the team will work hard to deliver solid results for the rest of the year..

And this is Wes. I'd just add that from quarter-to-quarter, we may see a little bit of variability, but I think the thrust of your question applied to the long-term is exactly right. We see AS on an upward trajectory over the next number of years as we are executing that broad variety of programs that I mentioned in my remarks.

So while quarter-to-quarter, we may see some little ups and downs, the trajectory that you mentioned is the right one..

Okay, thanks..

Thank you, George..

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

Good afternoon..

Hi, Sam..

Hi. I was wondering if you could talk a little bit philosophically, I guess, about the cash balances. Just looking at you're down to about a $1.1 billion this quarter, it's kind of as low as I can remember. I know the second half cash is always better than the first half, so that will build.

But just thinking about what is the right amount of cash to run the business? Does that make you think differently about how you return cash to shareholders? I'm just trying to think about how we see things move from here?.

Thanks for the question, Sam. I would comment that we are satisfied with the amount of cash we have on the balance sheet and satisfied with our liquidity position. It's a bit lower than where we were the second quarter of last year. I think we were a bit north of $1.25 billion, somewhere shy of $1.3 billion last year at this time.

So, we're looking forward to a strong second half in terms of cash generation. I think you'll remember that that's pretty consistent with our normal historical pattern of cash generation, although I'm determined to figure out how to pull some of that forward into the first half of the year as we look forward.

But overall, we don't have any concerns about where we ended up the second quarter on cash and look forward to solid second half of the year and then delivering continued solid cash results from there as we move forward..

Sam I'd just add it's always the balance. We want to put our cash to work and making sure that we've got the right balance between putting it to work and having the adequate balance we need just to run the business is somewhat a reflection of the volatility that we see from time-to-time in the market space.

During the period of time where we were dealing with shutdowns and some of those other issues, that biased us a little bit more in the direction of a more significant balance. It's hard to tell that we're necessarily in a period of greater stability on funding. We'll see how this whole CR process works out.

But it's working to find the right balance in that overall equation with a strong bias towards putting our money to work..

Thank you..

Your next question is from Noah Poponak from Goldman Sachs..

Hey, good afternoon, everyone..

Hey, Noah.

How are you?.

Pretty good.

How are you, Ken?.

Good..

Hey, could you update us on the FASB change and the possible revenue recognition change, where your units of delivery, and I don't know if there could be a change or not on F-35 for you?.

Sure. The rev rec standard, we do expect will result in a change to a number of our programs, F-35 probably being the largest in terms of those programs for which we are on units of delivery.

If you think about it, essentially, we will take units of delivery sales in the year of adoption and we'll take those units of delivery out and replace it with cost to cost sales. So, generally, we expect it to have a not too significant impact in terms of any particular year in regards to the P&L, and the sales and earnings to be generated.

Certainly, something we're spending a fair amount of time on. Our accounting folks are working hard on that. We do expect to have that fully analyzed and our method of adoption identified by the end of 2016.

And I'd say we're well on track to dealing with that issue, and we don't see it as significantly impactful to any particular P&L as we look forward..

Okay.

It seemed like potentially something like F-35, where the program is ramping pretty significantly and you're a long lead supplier, if you had to switch overnight to POC, it would sort of create just like a step-up in the revenue, but it sounds like that's not necessarily the case?.

The pull-forward could result in a little bit more revenue than units of delivery. It really depends on timing in terms of what's being delivered that quarter versus the work in flow. And so, it's still a little bit out in front of us. The closer we get to it, the more accurate I could give you an impact of what likely increase.

There likely would be some increase there, although some other programs could result in some decreases going the other way. So, as we get closer, we'll be able to give you a better picture of that..

But you think you'll be on it in 1Q 2017, basically?.

1Q 2018..

Oh, okay. So, you'll just....

And we'll have a likely retrospective look back..

Okay.

So, did you say you'll decide exactly what you're doing by the end of this year?.

By the end of the year, yeah..

But you won't actually switch in the financial statements till 2018..

That's right. We'll select our method of transition, but the transition itself will be the first of 2018..

Got it. And....

And your next question is from the line of Doug Harned from Bernstein..

Thank you. Good afternoon..

Hey, Doug..

Hi, Doug..

I wanted to talk about Aerospace. And you talked about expectations over the next few years for a ramp there.

When you look at across those next few years in terms of margin, you've clearly got the B-21 ramping up in development, I know it's something you probably can't say much about, but when you look at Aerospace as a whole, do you think you can maintain margins at current levels even with the mix shift? And I would imagine the people working there would like that, too, given that incentives are tied to margin levels..

Thanks for the question, Doug. Let me start and maybe Wes will add some comments at the end. But in terms of mix, we do have some additional development coming in. You talked about the B-21 and there's always a mix of development versus production work, as we look. But the other piece of this is that we've also got a fair amount of production.

We spent a little bit of time talking about F-35 today, as that production should mature and ramp. E-2D is in mature production. And Wes mentioned we're looking to get to LRIP on Triton. So, we've got a bit working both ways. We do incentivize the team to perform better than the benchmark and its peers. That benchmark continues to be 11% for Aerospace.

And I would say maintaining historically a strong level mix of production versus development, I think will that move one way or the other, yes. I think development could move up, but I don't think it swings so wildly that margin rates are unsustainable. I think I've described margin rates as kind of relatively range-bound.

We certainly don't expect any precipitous drop in rates. And one thing we know is, is the team out there will continue to drive and find ways to perform..

Yeah, I think Ken said it well, Doug. I guess the way I would frame it is, if you just look at the mix of development and production that we have, we have every opportunity to continue to do well on margin rate, so it comes down to performance. The other variable is how much more we win, and we'd like to win some more.

And we think we are well-positioned and we're working hard to provide our customers with some very innovative offerings, so we'd like to continue to add development content to the business as we can.

But at the same time, and Ken mentioned this, we're going to the team incentivized based on our benchmarking process, where we need to do better than the benchmarks. So, we only want good wins. We want wins that will help us continue to perform well, and where we're going to be able to deliver the customer really good capabilities.

So, our future wins could have, if you think about it in broad context, could have some impact on the mix. So again, it's going to come back for performance (33:24). So I think we have a good opportunity to continue to do well on the margin rates at AS while we continue to work on some additional captures to continue to grow that business.

And the bottom line is we got to perform..

So, the mix as you see it now, it seems reasonable to you that you could keep margins here if you perform well, that there's no fundamental trend that's going to take them down, I guess?.

I don't see a precipitous drop in the margin rates, assuming we continue to perform..

Okay, great. Thank you..

Your next question is from the line of Joseph DeNardi from Stifel, Nicolaus..

Yeah. Thank you very much.

Wes, sorry for another question on Aerospace, but if you look at the three headwinds you've got this year, the James Webb, AHF (sic) [AEHF] (34:13), and F-18, are those more of a headwind next year or does that start to ease a little bit in 2017?.

Joe, I would say that largely those headwinds start to ease a bit in 2017. The F-18 should kind of flatten out and stay at a delivery level of about two a month. The others could see a little bit more decline as they continue to mature, but I don't see it as a particularly significant drop in those programs..

Okay. Thanks, Ken..

Your next question is from Jason Gursky with Citi..

Hey, good afternoon, everyone..

Hi, Jason..

Hey, Jason..

Wes, I was wondering if you could dive a little bit deeper on the TS restructuring.

How long is this going to take? When do you think revenue streams could inflect higher there to get some growth out of it? And, just what are you going to be prioritizing there as you work through this process?.

So, it's a little hard right now to project on the timeline for it, just given the fact that as we make our decisions, we, at the same time, make sure that we continue to support our customers. We're a company that never leaves a customer high and dry simply because we've decided that we're changing a part of the portfolio.

And, I'll give you an example on that. Our approach in state and local, where we've been pretty clear that we've been ramping down our business in the state and local marketplace over the last few years. And so, we're not rebidding on a lot of new things.

But, in many cases, those customers need us to hang in there a little bit longer to affect a smooth transition. And we're committed to making sure we support them. So, a lot of the variability here is on the nature of the customer needs to ensure that nobody gets left hanging in some manner. We want to make sure we support them well.

My experience on these transitions, as we've gone through them over the last few years, suggests that it takes usually, at a minimum, about a year, but sometimes it can be a little bit longer than that to affect the portfolio shaping. Some of that gets assisted by where the new bids are.

And we can elect in many cases to just simply not rebid in an area that we're working to transition out. And you asked for a few examples. So, state and local is one, where we are continuing to work our way down through that process.

There are other areas, both in the global logistics and modernization programs, as well as our modernization services, and our advanced defense services businesses, where we're looking at the nature of how the customer is buying.

If their approach to buying is shaping things more in the direction of the commodity services, that's really not the part of the marketplace that we see ourselves as adding great value.

We tend to do a better job for our customers in areas where they need some aspect of technology componentry as a part of what they're doing or they need engineering applied to the outcomes for the products or services that they're looking at. And that, over time, continues to shape and shift a little bit.

So, this is really down at the business unit level, where we're sorting through each of these areas and making those decisions. And I think you'll see the outcomes of some of those decisions as we begin to talk a little bit more about 2017.

And then, that'll allow us to lock in on it and make sure we're investing on it the right way and move through that as we move into 2018 and beyond..

Wes, let me just add to that, that a couple of other things to think about. One, for TS, I think it's important to think about its intercompany focus and the work that it does supporting and being really integrated with MS and AS. And you've seen that growing as a percentage of TS's sales.

And I would expect that's going to continue to be a strong and important part of its business. One other impact as we look forward was a re-compete this year, where we bid what we believed was an appropriate margin rate for this type of work. And unfortunately, were not successful in that bid.

So, that impacts the business as we look forward as well, and all that's factored in..

Okay, great. Thanks, gentlemen..

Your next question is from Carter Copeland with Barclays..

Hey. Good afternoon, Wes and Ken..

Hey, Carter..

Hi, Carter..

Just to follow up on that, Wes, when you look at TS, I mean, if you have someone else who doesn't have the same return hurdles or the same technology componentry focus that you do, is there a scenario where divesting a business as opposed to non-bids works, I mean there is obviously a lot of movement in that marketplace, a lot of changing business models in that marketplace, could that be part of the consideration as well or any color you can provide?.

We always look at that full range, Carter, of portfolio options, but I will tell you in this case, what we see is the redeployment of people.

We've got a great asset in that business of just extraordinary people, who can provide really good returns and provide really good outcomes for our customers as we better deploy them into these areas where we think there are better opportunities.

So, my general bias in looking at a business like TS, where we do have such an amazing group of employees, is to just more effectively leverage that capability that we have into a place that makes a lot more sense for us to be, and, again, being mindful of it and respectful of our customers' needs, so that we are not causing any customers any grief in the process.

So, that's generally how I see this going. As always, and you've seen us do this over the last number of years, if it's very, very clear that some part of our business would be better executed in the hands of another party, we're the first to step up and make that happen.

But, in general, just giving you my impression of how I see things headed at TS, I have a bias towards redeploying the amazing people that we have in that organization to ensure that we can be on the better trajectory..

Can you quantify how much redeployment that it is as a percentage of the total?.

Not really, and I want to be careful that this doesn't come across as a huge sort of instantaneous transition of the business. We're just talking about the general vector that we see the business on. Again, I don't see a precipitous drop in any aspect of that business as we move into 2017.

But when I compare the three businesses, AS and MS to TS, I would say that we're looking for a more near-term reflection of our growth opportunities at AS and MS and that will lag just a little bit in TS. That's the way I would frame it for you..

Great. Thanks Wes..

Thank you, Carter..

And your next question is from the line of Howard Rubel with Jefferies..

Thank you very much. I want to turn the discussion a little bit towards some of these new innovative programs that you're starting to capitalize on.

I think there is two and maybe three, one is SEWIP, second is JCREW and then third, it seems to me that you've probably won some space situational programs, and could you address sort of what you see, both with that portfolio and how to build on it, Wes?.

Yeah, thanks, Howard. I appreciate it. There is, as you point out, so much innovation that's occurring right now and attempting to insert some very new thinking into the way our customers are executing their missions. SEWIP Block III and JCREW are perfect examples of that. And we're really proud of those wins.

And I'm especially proud of how the teams approached those areas.

Those are reflections of some much of what we do in the company that takes a number of years of investment in advance to really generate the level of technology capability that we can demonstrate to the customers and show them that they can achieve and some of these cases, something that they didn't actually anticipate being able to do when they began thinking about the way they were going to formulate their mission capability.

And in all of these areas as we are able to not only advance the technologies themselves, but better integrate these rapidly-moving technology spaces, we're creating these types of outcomes for our customers. And I'm especially excited and proud about that.

SEWIP III, you mentioned a really good example of how the Navy is thinking aggressively ahead on electronic warfare. And, it needs to, given the complexity of the threat environment that the Navy is going to be facing as they move forward.

And, in JCREW, if you looked at what we've been able to do over the years in our communications space through the application of software-defined capability and the ability to integrate a lot of different ways of operating into singular devices, I think that's a really good example of that outcome. You mentioned space.

And space is an area that I really think we're on the beginning next steps of a change in the way of looking at the space portfolio for the nation. For years, we operated our space assets with sort of the perspective that we were in some sort of sanctuary in space, and didn't really have to worry about threat.

And that's changed dramatically over the last few years. You've heard a number of senior officials in government talk about that shift in the thinking and that understanding.

And, consequently, as we go forward, I think just about all of the space missions that are going to need to be recapitalized are going to be recapitalized with those concerns in mind, which inevitably moves the architecture of those missions in the direction of the application of higher-end technologies, which is what we do.

So, I think there will be quite a few very good opportunities for both our company and the companies with whom we partner in addressing these new needs in space.

And we are investing to make sure that we're in the right place on that and forming the right partnerships to ensure that we can together bring the capabilities our customers are going to need.

So, there's actually quite a bit of work that's going on in our company and across our industry right now on the higher end of these technologies to ensure that our customers are going to be able to get what they need from us..

So, if I interpret that, there is some study contracts that have moved forward and you're part of that?.

There are, sort of across the board on a lot of these things, much of the advanced study work, as you might imagine, is classified, so we're not able to talk very much about that, but I would just say there is quite a bit of effort and energy that our customers are putting into making sure that the application of these advanced technologies really does enable them to differentiate their war-fighting capabilities..

Thank you very much..

Thanks, Howard..

Your next question is from Cai von Rumohr with Cowen & Company..

Yes. Thank you very much. So in your first quarter 10-Q, I think you identified $75 million difference between what you were assuming in recovery on equitable adjustment claims versus what your claim was. And I think you alluded to an REA in your current 10-Q.

Could you give us the status of those first? Were both of those two REA's from the first quarter settled here in the second quarter? And was the one mentioned in your Q here that you settled in July, is that included in these numbers? And if so, you know, what was the recovery? Thank you..

Cai, thanks for the question. On the REAs, let me kind of cover it broadly. The one REA that we discussed in the 10-Q was resolved in July. It was reflected in the numbers and does not result in a material impact for a disclosure in the financials or the 10-Q.

In terms of the remaining REAs, there is a remaining balance that we believe is not material for disclosure, working through that, or those, in due course and don't expect any material issues arising out of that, certainly to the downside.

And to the extent there's an immaterial upside, we'll include that in future 10-Qs or 10-Ks, as the timing is right..

And then, you mentioned also in the Q that you have, I guess, another potential $40 million or so tax pickup.

Could you basically explain what's that about? And what has to be triggered to allow you to realize that?.

There is a number of outstanding tax audits, Cai, that continue through the process. And some roll their way out and/or realizes.

We saw 2007 through 2011 was this quarter and other audits, be they Federal or state, or other international jurisdictions, sometimes roll their way into what we call the early warning disclosure in terms of what changes we could see in the next 12 months.

So, it's just kind of a rolling inventory of a large number of claims and audits that our tax team works very hard to stay on top of and maximize our cash tax benefits, while always making sure we're in strict compliance with the tax laws and regulations..

Thank you very much..

Your next question is from Seth Seifman with JPMorgan..

Thanks very much and good afternoon. In Mission Systems, I think you noted in the 10-Q that the backlog was down slightly year-to-date. I think after the first quarter, it had been up a bit. I wonder if you could talk about the order environment there and the possibility of ending out the year with that backlog higher..

Seth, I think that one of the complications of backlog is it's really hard to analyze on a quarterly basis.

And we certainly, being kind of a longer cycle businesses at AS and MS, we do see the impact of – I wouldn't call it necessarily seasonal change in the backlog, but kind of fluctuations in terms of increases as large orders come in and decreases as you kind of burn those down.

So, I would say it's not unusual, pretty consistent with our historical timing of booking awards and our backlog balances.

And that's one of the reasons that we don't guide on book-to-bill is it's just, in a long cycle business, it can be a bit lumpy, and dependent on timing of getting awards in the door and when those contracts are signed and negotiated..

Okay, understood. Thank you..

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

Thank you..

Hi, Hunter. Good morning..

Hey. How are you? So, CapEx, the low end came up by about $100 million. Well, not about; it came up by $100 million. And, I think you said the building purchase was about $240 million versus I think the prior placeholder was like $300 million.

So, what's driving the increase there? And, as you think about the next couple years, two, three years out, are you finding that there's maybe some unanticipated required investments with some of the ramping development work that maybe means CapEx stays a little more elevated than maybe some people were expecting, or you guys were originally expecting, maybe closer to the $1 billion level going forward for the next few years? Thank you..

No problem, Hunter. I would say that I don't think that this – the profile of the CapEx for 2016 is surprising to us. We fully expected that we'd have the facilities in the early half of the year. And we've been executing on that, as Wes mentioned. We've got a couple other major projects that are working their way through the system.

And we fully expected that some of that would be second half-loaded. So, we see a higher level of CapEx on the non-facilities side of things in the second half of the year. And, we fully expect to be within the range of $800 million to $1 billion.

In terms of the future CapEx requirements, I think what we've talked about is, is that we expect to stay elevated from our historical amount, if you look back a number of years, for a few more years. And what we're seeing today, I don't see any significant change in our previous expectation as to where we are today on that outlook.

So I think we would continue to say not necessarily the number of facility actions in front of us as we saw the first half of this year, but we do see as we grow the business and we're investing for the future, profitable growth that we see in front of us, we'll see an elevated level for a few more years, but, no change from where we've been in terms of the longer-term outlook..

Okay. Thank you..

Your next question is from the line of Robert Spingarn from Credit Suisse..

Good afternoon..

Hi, Robert..

If you'll indulge me, I was going to try and tie two things together here into one question related to LRIP 9 and 10. And, the first component is the F-35 margin, which, Ken, I think last quarter, you mentioned was below where it might be relative to its level of maturity, the program's level of maturity, at this stage.

And then, the other part is the logistics side of the equation, which you both talked about a few questions ago. With this LRIP 9, 10 deal, I guess this is to you, Ken. Are you getting where you want to get on margins? And then, how should we think about this Blueprint for Affordability? And then, separately, the sustainment cost reduction initiative.

What are the anatomy of these programs? Are they real initiatives that you've cooperative with a customer or are they euphemisms for price decreases?.

Let me start on the margin side and LRIP 9, 10. And then, I'll turn it over to Wes on the Blueprint for Sustainability. And I can comment briefly on Blueprint for Affordability, as I was a bit involved in that when I was in my previous role at the AS sector.

In terms of F-35 margin, I would say that, yes, in fact, the margin rates we're realizing on that program is not what we expect at this level of maturity. We're talking about LRIPs 9 and 10 moving into full rate production, and we would expect that the margin would be a bit higher than where it is today.

That being said, the negotiation of each lot is only the first step in that process, and you've got to perform in order to realize the margin. So, we've been able to work hard with Lockheed Martin to get to an MOU on LRIP 9 and 10 for AS, and we were previously there on the other sectors.

And, now it's a matter of performing and delivering the margin that we expect out of that program. From a BFA perspective, we did invest along with BAE and Lockheed Martin in the BFA through I guess that was in 2012-2013 timeframe.

And, I would say that we've been making good progress on that working with the industry team and the government through that process. Any other questions on BFA, I'd refer you to Lockheed Martin for any other comment..

Let me just comment broadly on the blueprint investments, because just the tone of your question, I think, perhaps conveyed a little bit of a negative view on them that I think is inaccurate. These investments, they are team investments that are focused on helping our customer get cost out.

And as we do that, they have inherent in them a return mechanism for the company. So, this is not sort of a side-swipe at some way of reducing our margin or something.

This is an overt decision by the industry team to come together, to work on ways to actually get the cost, the unit costs in the case of the BFAs and then the sustainment cost in terms of the BFS, to get the cost structure into a place where our customers can afford more of the capability.

So, from an industry perspective, we are only doing this, because we see a benefit to the program and ultimately an economic benefit to those who are participants in the program.

And it's a win-win, because the government, our customers, get an economic benefit from these investments as well, and have worked very closely with us in both structuring the investment strategies and programs, and on ensuring that there is a good return mechanism.

So we see them as very positive mechanisms, very supportive of the program objectives. And I think it has been a really good reflection on the partnership approach that we have together across the companies on F-35, that we're able to make something innovative like this work so well. So, I'm very proud of these blueprint initiatives.

I think they're a very good thing..

Wes, I think that make sense. The part I'm curious about is, I would think that you and Lockheed and BAE are working on these sorts of things in any event to get the cost down, and I'm just curious as to the role that the customer plays here in catalyzing this..

So, what's neat about the blueprint process, and you're right. Of course, we're always working together to figure out ways of taking the cost down. It really does create a really good team environment with the customer, because in some of these areas, they have to make decisions to do things a little bit differently..

I see..

So, it's a very good way of crystallizing a very effective joint process with not only the partners, but the customer to benefit the program. So, I think it's a good idea, and I'm glad to see us moving forward with these..

And just on the logistics side, sustainment side, just based on what was said earlier on other programs and then we have this BFS, I guess it is on F-35, are there different flavors here of sustainment programs? It sounds like some have become LPTA and maybe others aren't?.

All right. There is probably enough variability across sustainment programs as there is the number of sustainment programs.

There is a lot of different models that are utilized by different customers, depending on how much work the government itself wants to do, how much they want to contract out, the nature of the economic relationships they want to create. So, it's a marketplace with a lot of different business models.

And I think that's appropriate, because we have many different types of systems at different stages of their lifecycle with different levels of technology, different desires for modernization. So, it's a very interesting and dynamic marketplace..

Hey, Robert, we're going to cut it off at this point in time. So, I'm going to turn it over to Wes for final comments..

All right, well, thanks, Steve. Let me just wrap up by thanking our team again for developing an approach over these last number of years that has allowed us to consistently deliver solid results. I think this quarter was another good demonstration of the team's focus and commitment on performance.

But also the team is doing such a great job in positioning us so well for the, not only the remainder of this year, but for the longer-term and for working closely with our customers to satisfy their needs as we go forward. So, thanks, everyone, for joining us on the call today, and also thanks for your continuing interest in our company..

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