Good day, ladies and gentlemen and welcome to Northrop Grumman’s Second Quarter 2019 Conference Call. Today’s call is being recorded. My name is Natalia, and I will be your operator today. At this time, all participants are in a listen-only mode. [Operator Instructions] I would now like to turn the call over to your host, Mr.

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

Thanks, Natalia, and welcome to Northrop Grumman’s second quarter 2019 conference call. Before we start, please understand that matters discussed on today’s call constitute forward-looking statements, pursuant to Safe Harbor provisions of federal securities laws.

Forward-looking statements involve risks and uncertainties, which are noted in today’s earnings release and our SEC filings. These risks and uncertainties may cause actual Company results to differ materially.

Matters discussed on today’s call will also include non-GAAP financial measures that are reconciled in our earnings release and supplemental presentation. On the call today are Kathy Warden, our CEO and President; and Ken Bedingfield, our CFO. At this time, I’d like to turn the call over to Kathy..

Thank you, Steve. Hello, everyone, and welcome to today’s call. We had an excellent second quarter results across the board, including business capture, backlog growth, sales, earnings and cash. Based on our strong performance and our outlook for the remainder of the year, we are increasing 2019 guidance. I want to thank the Northrop Grumman team.

I’m particularly proud of our ability to deliver innovative, quality products and services, which enable global security and human advancement. Starting with Space, as we celebrate the 50th anniversary of our nation’s Apollo 11 lunar landing, we are proud of our strong legacy in supporting each of our nation’s manned space flights to-date.

Looking forward, we are poised to continue supporting manned space flight through NASA’s Artemis program, which is expected to return humans to the moon by 2024. In addition, this quarter, Innovation Systems has passed its one-year anniversary as our fourth sector, and I’m delighted with the progress we’re making.

Costs and operational synergies are on track and our margin rates across the Company are benefiting from the synergies realized since the acquisition. We are also realizing revenue synergies sooner than we expected. A good indicator of our success in capturing revenue synergies is our growing share of restricted work.

We booked $843 million in restricted space awards during the second quarter and $4.5 billion in the first quarter. At the Company level, restricted work across multiple domains continues to grow as a percent of total revenue.

This demonstrates our strong alignment to the national defense strategy and our ability to leverage our entire portfolio to create innovative solutions for our customers. We booked net awards of $13.5 billion in the second quarter and $25.8 billion year-to-date.

Now, net awards are approximately 1.6 times sales and our total backlog is up 18% to $63 billion. The large multi-year awards we are capturing across the Company are the building blocks for sustainable long-term profitable growth.

Year-to-date, Aerospace Systems has booked net awards of approximately $13 billion and total backlog has increased 28% since year-end. In the second quarter, we booked $3.6 billion for the E-2D. Approximately $3.3 billion was booked at AS for the U.S.

Navy’s next 24 Advanced Hawkeyes and associated deliverables, with the balance awarded at Mission Systems. In addition to U.S. Navy Aircraft, the multi-year includes an option for the nine additional E-2Ds for Japan. In the second quarter, we delivered the first four E-2Ds currently under contract for Japan.

And we anticipate being under contract for the additional nine by the end of this year. On the F-35 program, we booked awards of over $4 billion in the quarter across our four sectors.

At Aerospace Systems, we finalized to $4.9 billion agreement for production lots 12 through 14 center fuselage units, and booked an award of approximately $3 billion, net of previous incremental funding. Mission Systems added $1 billion of award for additional F-35 radar CNI and DAS production.

And IS and TS together, were awarded approximately $100 million for their scope on the program. Moving to Innovation Systems, year-to-date net awards totaled approximately $3 billion. In addition to our prime role of supporting U.S. government hypersonic weapon systems development efforts, we are also supporting Lockheed Martin and Raytheon program.

In the second quarter, Lockheed Martin awarded us $265 million for the Intermediate Range Conventional Prompt Strike program and IS is working with Raytheon on the Hypersonic Air-Breathing Weapon Concept or HAWC program.

Shortly after the end of the quarter, Space Norway awarded IS a $250 million contract for its Arctic Satellite Broadband Mission to provide critical ground infrastructure and to design, manufacture and integrate two satellites.

This activity increases utilization of our hot production line enhancing affordability and production efficiency across our customer base. In addition, Aerospace Systems is developing payloads for the Space Norway satellite, which will be hosted on the IS bus.

This is another example of revenue synergy in the space domain, and it highlights our industry-leading end-to-end capability. Now moving to Mission Systems. We signed a $1 billion contract to begin full-rate production on our G/ATOR program after achieving initial operating capability in the first quarter.

G/ATOR is our first ground-based gallium nitride or GaN radar to be operationally fielded. It combines five legacy systems into a single solution, improving mission performance and reducing customer costs.

G/ATOR provides real-time 360 degree situational awareness against a broad array of threats and we see the system, having strong opportunity for international sales. Mission Systems is also supplying the upgraded integrated avionics suite for the Black Hawk program, which entered LRIP in April.

An initial 25 kits were ordered under this LRIP and the Army plans to upgrade 760 Black Hawks with this avionic suite. And lastly, the Army awarded us an OTA for agile software development of their next incremental build with the IBCS capability.

This competitive win signifies our customers’ confidence in our ability and commitment to accelerate delivery of critical new war fighting capabilities. Mission Systems, year-to-date net awards totaled approximately $8 billion and backlog is up 14% from year-end.

The common thread running through our successful efforts on G/ATOR, Black Hawk as well as IBCS is our modular multi-mission, open architecture approach to next-generation defense electronics.

We are reaping the benefit of substantial technology investments we’ve made to support development of solutions that give the customer advanced performance and greater affordability, as well as the ability to rapidly address future threats. Turning to Technology Services.

Global Services booked $223 million for an international training program, a $70 million task order to support the Joint Chiefs of Staff and a $59 million contract to provide enterprise defense cyber operations for the Marine Corps.

In Global Logistics and Modernization, we secured a $162 million Army award for sustainment of the Hunter unmanned aircraft system. And on EA PUP, our Electronic Attack Pod Upgrade Program, the Air Force exercised a $44 million option. Our business capture has been outstanding year-to-date and we expect strong bookings to continue.

We have a robust opportunity set across the Corporation with large potential awards in restricted space, National Security Space Launch, GBSD and product line expansion in airborne radar and electronic warfare.

In May, on the National Security Space Launch program, Innovation Systems successfully conducted a full scale of static fire test of the first stage of our new OmegA rocket.

This milestone keeps OmegA on track to performance first launch in 2021 and begin operational launches of National Security payloads in 2022, meeting the congressional mandate and U.S. Air Force requirements. And as you know, the final RFP for GBSD was released last week.

Northrop Grumman has been a trusted systems engineering partner for every new ICBM system over the last 60 years. We look forward to offering a highly capable, technically measured and affordable solution that addresses evolving threats and fulfills our nation’s critical nuclear deterrence mission. Turning to P&L.

At the midpoint of the year, sales were up 20%. As we indicated last quarter, Mission Systems sales growth is accelerating and the top line is stabilizing at Technology Services. Looking ahead, we continue to expect sales of approximately $34 billion for 2019.

In addition to solid top line results, our sectors generated a 26% increase in second quarter segment operating income and 70 basis point increase in our segment margin rate, driven by strong performance and cost synergies.

Year-to-date, our segment OM rate is up 60 basis points, and we are raising our guidance for the year to approximately 11.5% from low-to-mid 11%. EPS rose 12% on the quarter and we now expect full-year earnings per share to range between $19.30 and $19.55. Cash generation was also a highlight this quarter.

Our businesses generated $1.6 billion and after capital expenditures of $252 million, free cash flow totaled approximately $1.4 billion. For the year, we continue to expect 2019 free cash flow of $2.6 billion to $3 billion. And beyond this year, we expect to continue generating strong cash as we grow the business.

We continue to execute a balanced cash deployment strategy. In addition to capital expenditures, we increased our quarterly dividend by 10%, we continued repurchasing shares toward our 2019 target, and we will retire $500 million in debt in August. Now turning to the U.S. budget.

We are pleased by reports the Congress and the Administration have reached an agreement on fiscal years 2020 and 2021. This should prevent harmful budget cuts and disruption. Predictable funding enabled our customers to increase investment in critical technologies needed to stay ahead of rapidly advancing global threats.

We believe our nation’s leaders understand the threats we face and will act to provide the necessary resources to modernize key capabilities. Northrop Grumman continues to invest in advanced capabilities to enable long-term value creation.

Our new franchise programs and leading technologies demonstrate the success of our investments and an approach that combines innovation with affordability.

We believe that our portfolio and cost structure, our competitive differentiators that is evidenced by our business capture success, will continue creating value for our customers and shareholders. Now, I’ll turn the call over to Ken for a more detailed discussion of our financial results and guidance.

Ken?.

Thanks, Kathy and good afternoon, everyone. I also want to thank our team for a strong second quarter. I’d note that our presentation includes an EPS bridge from second quarter 2018 to second quarter 2019, and the bridge to our updated 2019 EPS guidance.

As you can see from the bridge on Slide 6, the majority of the EPS increase is driven by a strong year-to-date operational performance and full-year expectations with the remaining $0.10, primarily reflecting lower expected unallocated corporate expense. Let’s turn to the sectors.

Aerospace Systems rose 2% in the quarter, reflecting higher F-35 volume in Manned Aircraft and increased civil space activity in space systems. Autonomous sales were comparable to the prior period. I will note, second quarter sales were also unfavorably impacted by the timing of supplier costs.

Operating income rose slightly and AS operating margin rate was comparable to last year’s second quarter. We continue to expect AS sales for the year in the high $13 billion range with a mid-to-high 10% operating margin rate. No change to prior guidance.

At Innovation Systems, based on pro forma sales comparisons, second quarter sales rose 8% due to higher volume at Flight Systems and Defense Systems. Flight Systems had increased volume on military aerospace structures and launch vehicles. Defense Systems had higher volume in tactical missiles, including the AARGM program.

IS operating income was $169 million with a strong operating margin rate of 11.3%. IS year-to-date margin rate reflects several favorable adjustments and the risk [Audio Gap] (15:01) the largest of the businesses grew above the sector growth rate.

Increased volume on infrared countermeasures, airborne radar and restricted programs, drove the sensors and processing growth. And higher volume on restricted programs drove growth at advanced capabilities. At Cyber and ISR, we had increased volume on space programs.

With previously discussed program completion headwinds behind us, Mission Systems growth rate has accelerated as we ramp up on a number of programs, such as F-35, G/ATOR, CIRCM and IBCS, to name just a few. We continue to expect MS revenue to grow in the low-to-mid $12 billion range this year with a margin rate of approximately 13%.

No change to prior guidance. At Technology Services, I’m pleased to report sales were comparable to the prior year period. TS operating profit increased 19% and operating margin rate increased 170 basis points to 10.8%.

Looking ahead, previously discussed program completion headwinds moderate in the second half, and we expect TS sales will continue to stabilize. We continue to expect TS sales in the low $4 billion range, no change to prior guidance. And based on strong first half performance, we are again, raising guidance for TS operating margin rates.

We now expect a low 10% range versus prior guidance of approximately 10%. As we roll all that up, we continue to expect 2019 sales of approximately $34 billion, and based on strong year-to-date performance and sector guidance increases, we are increasing guidance for total segment operating margin rate to approximately 11.5%.

Below segment OM, we now expect unallocated corporate expense of $225 million versus prior guidance of $250 million. Higher segment OM, along with a lower unallocated corporate expense, moves our full-year guidance for the total operating margin rate to the high 10% range.

Through the first half of the year, our effective tax rate is 16.4% versus 17.5% at this time last year. Our year-to-date effective tax rate reflects a higher level of research credits than we currently anticipate for the second half of the year. So no change to our guidance for 2019 effective tax rate.

As a result of improved performance, we are increasing our mark-to-market adjusted earnings per share guidance to a range of $19.30 to $19.55. This continues to be based on approximately 170 million weighted average shares outstanding. Turning to cash. It was a very strong quarter.

Second quarter cash from operations reflects improved trade working capital and higher earnings. Improved trade working capital includes the recovery of first quarter delayed billings that resulted from our ERP conversion to a single instance of SAP covering a majority of our businesses.

For the year, no change to prior guidance of $3.8 billion to $4.2 billion cash from operations and $2.6 billion to $3 billion of free cash flow, after capital expenditures of about $1.2 billion. We continue to plan share repurchases of approximately $750 million this year, subject to market conditions.

And as previously discussed, we intend to retire about $500 million of debt in the third quarter. Beyond this year, we expect growing cash flows as a result of growing earnings, some improvements in working capital, and our well-funded pension plans. As a result, we expect to have increasing capacity for value-creating capital deployment.

In summary, it was a strong quarter, a good first half, and we expect strong results for the remainder of the year. I think we’re ready for Q&A.

Steve?.

Thanks, Ken. I would ask each participant to limit themselves to a single question.

Natalia, would you please open the line for Q&A?.

[Operator Instructions] Your first question is from the line of Myles Walton with UBS..

Thanks, good morning..

Good morning..

Hey Myles..

I was wondering on the bookings front, obviously, extremely strong in the first half and particularly here in the second quarter. But I think in the 10-Q you filed, it also shows a slower burn of that backlog, about 40% over the next 12 months as opposed to the 50% over the next 12 months for the last several quarters not a couple of years.

Can you talk about how indicative that growth in backlog is about your acceleration of growth given that kind of reduced burn rate, if that’s accurate?.

Yes, let me start with that, Myles. I would just say that we are really happy to see the awards in the backlog that we’ve been able to get in the first half of the year. And as Kathy mentioned, we do expect to see continued strong awards in the second half of the year.

I would just point out that a number of the awards we’ve been booking like the B-21, E-2D, which is a five-year multi-year contract, F-35 lots 12 to 14, many of these programs are going to support multiple years of revenue.

And so given in particular, the awards booked in the first part of the year, first half of this year, the biggest ones being E-2D, as well as F-35 and then some restricted space activity, we expect those awards to result in sales for a multi-year period and give us really good visibility into strong sales growth for a number of years to come.

And so given those – the impact of those large, kind of multi-year awards, we do see that those will result in our backlog turning into sales and about 40% in the next 12 months versus our previous average of about 50%.

But it does not give us any pause as to any guidance we have given with respect to 2019 sales or with any indication we have given you about where we think we can be on 2020 sales.

And I’ll just remind you, we talked about a mid-single digit range on 2020, but given our awards activity and the opportunities we see in front of us, we think we’ve got opportunity to be in the higher end of that range for 2020.

So we think it’s really a good new story and supports, again, this – while we’ve been talking about the level of visibility we have into some long range sales growth for this business..

That’s great color. Thank you, Ken..

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

Hey, good morning, guys. Good afternoon, actually. Quick question, it’s my understanding that the RFP came out for – through the next phase of GBSD.

Can you share any thoughts on what you guys are thinking about it and how you feel about it?.

Yes. Thanks, Ron. This is Kathy. And as we look at the RFP, which did come out Monday, a week ago, we are really seeing what we expected to see and we are positioned to be able to support the U.S.

Air Force requirements and view this as a strong opportunity for our Company as I noted in my own remarks, we have been supporting the ICBM system for over 60 years. So we have the knowledge and the expertise needed to put together a strong offer for the U.S. Air Force, and we look forward to doing that.

There is a 150-day response period, so we will be submitting the proposal late this year and still expect an award in the mid-to-late part of 2020..

Great. Thank you very much..

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

Hi, guys. Good afternoon, Kathy, Ken. Kathy, you mentioned the revenue synergies that you’re starting to book. Obviously, a lot has been restricted, so you can’t really talk about it. But I just wanted to talk about how that flows through to growth.

Do we expect to start to see that layer in kind of the way Ken described, the burn rate on the backlog or is it something that happens faster? Maybe just some color there. Thank you..

Yes. We had talked about revenue synergy really not starting to kick in earnest to 2020, and as mentioned in last quarter’s call, as well as this one, that we are seeing those revenue synergies sooner than we expected. They are on efforts that are restricted and developmental largely, and therefore, you see a fairly slow ramp of that revenue in 2019.

You’ll see it more materially happening in the 2020 and 2021 time frame as we’ve talked about previously.

As you noted, it is in restricted space and today I shared the Space Norway award because it’s something that’s unclassified and that we can talk about, that demonstrates how in that case Innovation Systems and Aerospace Systems are working together, with IS providing the bus and the integrated ground, and then AS building the payloads for the satellite.

And so we’re going to continue to see those kinds of opportunities that are pulling end-to-end capabilities from across our various sectors together in multiple mission areas. But certainly, we’re seeing more of that in space than any other domain..

Appreciate the color. Thank you..

Your next question is from the line of Doug Harnett with Bernstein..

Thank you. Innovation Systems, and you had what as we would consider to be very good margin performance in the quarter. At the same time, you reported that the percentage of cost-type work had gone up to 29% from 26%.

So when you look – first, can you talk about what’s been driving the good performance – the good margin performance that at Innovation Systems? And then as you look forward and think about how you take parts of that business and link it to other – to Aerospace and to Mission Systems to capture revenue synergies, how do you ensure that you can continue to improve margin there?.

So Doug, let me start and then I’m going to ask Ken to provide some color on some activities in the first half of the year, which won’t be recurring, that did have a positive impact on the IS margins.

But more broadly, the good margin performance we’re seeing at Innovation Systems is due in part to their strong performance, and also in part to the cost synergies that we are realizing across the Company.

And the more that we’re able to utilize the facilities, the footprint and the infrastructure that we have across the business as a whole, IS and other sectors are benefiting from that.

So it’s not just the costs that we’re taking out that I referred to as cost synergy, but also starting to realize some of the operational synergy that’s having a positive impact on margins as well. In terms of our outlook for IS, we expect that strong performance to continue.

But as I noted, there were a couple of events in the first half that increased their operating margins. And Ken, I’ll ask you to share – shed some light on that..

Yes, I would just add that – you may remember, Doug, in the first quarter, we talked about the contribution of some commercial negotiations that we had planned to occur in 2019, but which occurred earlier than we expected driving the Q1 margin up.

And then in Q2 largely, we had some positive adjustments on some of our contracts that drove some additional margin rate.

And obviously, as we look at the second half of the year, we will work hard to manage risk and realize opportunities to try to continue to drive upside to margin rate, but we’ve had a real successful first half of the year so far, and still need to fill it in for the full year.

In terms of the question specifically about the 26% versus the 29%, I would just remind you that the previous-year period only included about three plus weeks of activity. So probably not a material change in terms of the revenue then versus revenue now.

But certainly we can perform on cost-type contracts and drive favorably as EAC adjustments there as well..

Okay, great. Very good. Thank you..

Thanks, Doug..

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

Thanks very much, and good afternoon. In Aerospace Systems, I guess, in the first quarter, we saw a step up in sales to about $3.5 billion and what you’ve done in the first half and the guidance sort of implies that we’re going to stay at about that level through the end of the year.

When do we see the next leg-up in Aerospace revenue? And then, Kathy, on the fourth quarter call, I think you talked in a little bit more detail about the three pieces, Manned, Unmanned and Space.

And so maybe if you could talk qualitatively about the outlook, now that you’ve got a few more of these words under your belt for the next couple of years for each of those?.

I’m going to ask Ken to start with giving you the outlook for the remainder of the year, and then I’ll talk to our overall view of the three segments..

Yes. So Seth, just a couple of comments, I guess, I would make for AS. I would say that as I referenced in my remarks, we did have that some timing of some supplier costs that moves the rate a little bit from Q2 into the second half of the year.

We did have a relatively tough compare for AS growth, which had grown 11% Q2 of 2018 on top of 11% the Q2 before that. So AS has been a solidly growing business and we continue to be comfortable that it continues to grow as we look forward.

We’re comfortable with our full-year guidance for AS, and feel good about where we are and where that business is going to be going in the next few years. And I’ll let comment – I’ll let Kathy comment more specifically on kind of the divisions within AS..

Yes. So we’ve been seeing growth across the three segments of AS Manned, Unmanned and Space, and each quarter that varies a bit. This quarter, Manned and Space were up offsetting some slight declines and Unmanned, just largely timing of deliveries in that business.

As we look forward and over the long-term, we see Space as likely the fastest growing segment of Aerospace. In that we see budget increases in that area, it’s a key area where we’re identifying and executing revenue synergies across the entire portfolio. So I do see that being one of our fastest growing segments in the Company over time.

I would say that Manned continues to benefit from a number of key franchise programs like E-2D, the additional work there with the U.S. Navy, but also it will be fueled by the international growth that we noted with Japan. And then of course, we continue with F-35 to see some decent growth in that Manned segment as well.

But Unmanned too, will has a nice growth outlook as we take Triton to early operating capability later this year. We’ll be ramping up production on that program over time and we also as you know have strong international demand there with units going to Australia and some interest in Germany as well.

So I really see nice opportunity across all three elements for the Aerospace portfolio..

Great. Thank you very much..

Your next question is from the line of Robert Stallard with Vertical Research..

Thanks so much. Good afternoon..

Good afternoon..

Ken, you mentioned that next year you should have some more flexibility for value-added capital deployment.

I was wondering what your priorities might be in that area, and whether pre-funding the pension might have moved up the agenda there?.

Sure. I’ll comment on that. I would say that as we look at the value-creating capital deployment opportunities, I’m probably not going to lay out the specifics for what 2020 might look like until we actually give guidance for 2020, but I would probably reference you to our consistent allocation over the past number of years.

In particular, I would note that we’ve been repurchaser of our shares for many years, dating back to 2003. We certainly expect that to continue. We’ve talked about what our CapEx profile looks like. Certainly, we continue to invest in technology through R&D investment and things like that.

In terms of pension, pre-funding, I haven’t seen that really rise too high on my radar screen at this point. I would say that we’ve had pretty solid pension returns year-to-date and that should help us from a required funding perspective.

And I think if you think back to our previous discussion, we didn’t have a whole lot of funding required for the next couple of years on pension, so not necessarily high on my radar screen.

My previous commentary on the debt pay-off in August of this year, we do expect that after we pay that off and then we look forward at our growing EBITDA and cash flows, we have the opportunity to get back to our preferred BBB+ credit rating at that point.

So lots of optionality on kind of managing the balance sheet, I would say, from that perspective and just lots of opportunity as we see again a growing set of cash flows to think about what the most value-creating capital deployment is..

That’s great. Thank you..

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

Good afternoon..

Hey, Rob..

So – hey there. Ken, just on that growing set of cash flows, you talked earlier about the strength of the multi-year awards, and that 2020 revenues could be at the high end of expectations. So it’s becoming clear the double-digit growth for free cash flow per share is possible.

So I wanted to – I know you don’t want to get too far ahead of yourself, but how do you feel about the 15% to 20% growth implied in the consensus free cash flow for 2020 of $20 per share?.

Great. Thanks for the question. As I mentioned previously, we’re not ready to give guidance for 2020 at this point. But I think we’ve been clear and I’ll continue to be clear that this is a business that will be a strong generator of cash as we look forward. And let me just walk through a few of the drivers of that for 2020 and beyond.

First, as you mentioned, we expect to continue to see solid growth and that’s for multiple years, given our portfolio alignment to what – our customers’ needs and the changing threats, and also as evidenced by our strong backlog. We continue to expect to generate strong margins and convert those margins into cash.

We invested ahead of the curve and we continue to expect our CapEx will moderate in future years. Pension plans are well funded to Rob’s question previously, some of the best funded plans in industry, to be frank.

And as we look forward, we continue to think that working capital should moderate a bit starting in 2020, and with more opportunity in the out years. So with kind of that framework, I think you’re hitting on the right issues or the right thoughts, and I wouldn’t argue with your thesis or assumptions on solid free cash flow growth..

Okay. Thank you..

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

Thank you. Good afternoon, Kathy and Ken..

Hi, Sheila..

Just on the missiles market, it’s been a big focus lately.

Maybe can you talk about Orbital ATK, what it’s thought incrementally in terms of technology and the exposure? And how do you think about the opportunities going forward and maybe your market share today?.

Thanks. So as we look at the missile space, there is clearly opportunity for us to continue to be key suppliers to Raytheon and Lockheed, which we’ve been doing in more traditional cruise missile space. And as I noted on today’s call, we continue with that partnering in the hypersonic weapons space as well.

And then there are some select instances and I pointed to some of those in our prior discussions, AARGM-ER is a good example, where we are the prime provider for the missile. We can provide that full integration and delivery capability, but we also have clearly the specialization and propulsion for other prime missile systems.

And so when we think about the business, we really do focus ourselves on continuing to evolve the technology in not only the propulsion systems, but our ability to provide guidance and the other elements of the system, the composite structures, that we can offer to others or in select instances, provide through our own prime offering.

We see that area growing for IS, as we see it growing for the other primes as well. And so we think that there is plenty of market opportunity for the three of us in that arena..

Thanks..

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

Thanks, good afternoon. Kathy, could you address your competitive win rate within TS, and whether you still think that TS as a whole, can return to growth in 2020? And could you also address your positioning within LTAM’s competition and a sense of that’s going on there? Thanks..

Sure. Let me start with Technology Services. Our win rate there in the first half of the year has been very solid, particularly on recompete for we’ve been able to defend the business that we have. And as you know, at the beginning of the year, we laid out a trajectory for that business.

The actions that we’ve taken have stopped – stabilized the top line and you’ll also see that we’re increasing the margin rate in that business because the team is executing to that plan quite well.

As our guidance indicates, I expect that, that sector is going to be flattish for the remainder of the year and we still expect that the sector will return to growth in 2020.

It’s largely driven by still having some headwinds from programs that have exited the Global Services part of the portfolio, while we are growing the global sustainment and modernization part of the TS business.

And I just want to also note that TS is providing us affordable life cycle support and modernization for systems and platforms that we build as well. And so they’re an integral part of many of the programs that we have and they offer us affordable options for that services component of the program execution for the bid.

So now, turning to the second part of your question around LTAMs, we are in an active competition there with submit to bid. And we feel confident that we have an offer that is competitive and is based on mature GaN technology. So we’ll wait to see what the Army thinks.

But we certainly are pleased to be able to participate in that competition and bring forward what we think is a good offer..

Hey, Natalia, next question..

Your next question is from the line of Jon Raviv with Citi..

Thank you. Good afternoon, everyone. Kathy, I know investments are very important part of the thesis and a differentiator for Northrop. One of your near peers would say, has engagement in M&A where investment is also a part of their thesis too.

So, any thoughts or perspectives on size and scale in light of some of those M&A moves and the importance of size and scale in being competitive going forward in the defense market?.

We’re certainly assessing the implications of the consolidation in our market, but let me share how we think about our own strategy. I see that we have a strong portfolio, especially now with the addition of Innovation Systems, and the portfolio is well aligned to our customers’ highest priority investment areas.

As you noted, we have been investing to support value creation. We’ve been investing in technology. I gave one example today, of a multi-year investment stream we’ve had in open Mission Systems Electronics and some of the programs that we’re now winning in Mission Systems as a result of those investments.

We, of course, have been investing in the facilities and equipment we need. Many of you have seen the expansion that we’ve done at Palmdale and across our other aerospace centers of excellence over the last several years. And we have a competitive cost structure as witnessed by some of our recent wins and the fighting of our cost advantages in those.

So when I look at where we are today, we have that portfolio and a strong basis to support business capture. We also have a strong and improving balance sheet that’s going to continue to allow us this investment optionality into the future. And we’ve demonstrated the ability to compete and win at our current scale.

So I see often that the quality of investment choices is even more important than the pure size of the investment itself. And looking at where we are with a focused strategy, well aligned investments to that strategy, I feel good about where we’re positioned..

Thank you..

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

Yes, good afternoon.

I was wondering Kathy or Ken, if you could go through some of the programs that are in unfunded backlog for Aerospace, since that was a big part of the jump in backlog this quarter?.

George, to be honest with you on that one, I don’t have the data in front of me, so I’d have to get Steve to follow-up to you with the specifics on that after the call today.

Is there another question, you wanted to go through?.

Yes. The EACs in Aerospace were down – were 54 versus 95 last year.

Can you talk through what might have been negative in the quarter, or why it was down by as much as it was?.

Yes, I’d be happy to go through that George. I don’t think there were really negatives of any significant consequence in this year’s second quarter. You may remember that last year’s second quarter, we did have an – a pick up EAC positive adjustments of about $69 million on a couple of restricted programs.

So really, if you look at it, it was more positives in last year’s second quarter. And if you think about this year’s second quarter with a similar margin rate, that would tell you that the underlying baseline EAC rates that we’re booking at is stronger than it was for last year’s second quarter. So we feel good about where we are.

I’m always careful to put too much credence into the EAC adjustments, because there’s always timing and fluctuations and ups and downs. And I think the most important thing is, we continue to perform. We have not seen an uptick in negative adjustments and continue to deliver consistent, strong performance at each of the sectors..

Okay, thanks..

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

Hi, Kathy. Hi, Ken..

Hey, Rajeev..

Hi..

Just an F-35 question, Lockheed’s been pretty vocal about getting the price down and it seems like they are successfully doing so, given that it’s one of your biggest programs.

How is that faltering down to you on the revenue and/or margin side? And as a follow-up, can you just highlight any contracts that are maybe rolling over the next six months, 12 months, 18 months that could create a little bit of noise, if you will, as we start looking at growth rates moving ahead?.

Sure, Rajeev. I’ll start on that one, and then Kathy can add any color. But from an F-35 perspective, I would just say that we are performing well, we’ve been delivering quality product on time or ahead of schedule.

We do have four contracts across a number of sectors, actually we have more than – more than four contracts now with IS and TS starting to see some of the logistics activity and sustainment. So it’s a significant program for us and we’ve been really working hard to support our customer Lockheed Martin, as well as the U.S.

government to deliver to that target that has been established from a price per unit perspective. And clearly our cost is a part of the cost reduction that our customer is seeing. So we feel really good about where we are on that program and we’ve seen really solid operational performance and we’re pleased with where that program is at this point.

And then with....

I think Rajeev, your second question was related to any recompetes coming up in the second half of the year, is that right?.

Yep, or just simply contracts that are rolling off. Yes, you got the right idea..

Right. So we have the remaining headwinds from the Virginia state outsourcing contract that is still in TS through the third quarter, and then we have in our Innovation Systems sector, a contract for Lake City Ammunition Plant and that is expected to be awarded in September of this year.

That would be about 10% of the revenue in Innovation Systems and it does not currently have economic value. So there would not be a profit impact, but we are positioning to compete for that contract and are expecting to hear in the next couple of months..

I would just add that the Ammunition contract that Kathy talked about, has a bit of a longer phasing than most contracts. So probably start – it would start to transition in kind of mid-to-late 2020, although we’ve put together a competitive bid and we’ve got a lot of confidence that we’ll see that production continue to be a part of our business.

And on VITA, I would just say that it’s had a more significant impact in the first half of the year and we see it really only about $75 million of headwind as we look at the second half for TS. So not a significant set of contracts that could sort of move against us..

Thank you..

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

Thank you. Good afternoon. I’ve got a follow-up on GBSD.

Can you help us frame the long-term opportunity for that program, including some of the sustainment work? And then also, please tell me I’m being too nitpicky, but Kathy, why did you include the phrase "technically mature" when you’re talking about the offering in your prepared remarks? And the nature of the question is basically, now that you’ve got a chance to review the RFP, is this less of a science project, if you will? Is there anything in there that would suggest that the customer is looking for proven technology as opposed to more sort of ambitious development work as they think about the award? Thanks..

So to frame out the opportunity for you, it clearly starts with the development of the modernized ICBM system and then moves into a production phase over a number of years to actually produce the capability and then would move to sustainment. But that sustainment scope is not part of the RFP for this offering.

That’s really – it’s about the development and the production phase of the contract and transition to sustainment. My phrasing on "technically mature" is because we’ve been executing tech maturation and risk reduction program for the last several years on GBSD.

And through that process, we have been able to retire risk and really mature our offering, and so we do feel that at this point in time, what we’re able to offer has wrung some of that risk that we would have identified at the early stage of our designed concept out of our offerings..

Thanks..

Your next question is from the line of Pete Skibitski with Alembic Global..

Good afternoon. Kathy, I wanted to get your thoughts on this idea from kind of early on in the Administration that, we’ve got to look at export control reform that could help with UAV exports. I think it gets to the Missile Technology Control Regime or some other controlling agreement.

I was wondering, have you guys seen progress on that or is it still to come, or did it just kind of fall off the table in terms of a major priority for the Administration? So initially I thought that maybe it could be a big opportunity for you guys..

Pete, it certainly hasn’t fallen off the table. We’re still engaged actively with the State department and looking at MTCR, and also specifically looking at certain countries that have requested our unmanned systems capability.

And I would say that we see much more opening to have that dialog and request from us to come forward with areas that have expressed interest and put some ideas on the table. It is slow to develop those into actual approval for export. And so, we’re still working through a process that requires a lot of steps for us to get there.

And so – look at MTCR also requires multi-national engagement to make a change to that policy. So that too, we expected and are seeing that’ll take some time..

Okay. So we should be patient on that front. Okay, thanks guys..

We are being patient, but not patient. We’re pushing..

Your next question is from the line of Cai von Rumohr with Cowen and Company..

Thank you very much. So Kathy, you mentioned you’re supporting two of your peers on hypersonics. With IS, you now have capability and propulsion, you have capability and guidance. Are you aspiring to become a bigger prime yourself and if not, why not? And also, one of your peers talks about defensive hypersonics as a bigger market.

Is that an area that you’re focused on, because there you also looked like you have the technology capability?.

Yes. Why don’t I start with the second part of your question, because in the counter-hypersonics part of the market, we are establishing ourselves as the prime. We have capabilities in the Missile Defense Regime today and in the space regime that we believe will be highly relevant to counter-hypersonics.

So that is an area that we are aggressively pursuing. In the case of hypersonics, thinking of the offense of weapon systems themselves. As I noted today, we do have prime effort. We also are supporting both Lockheed and Raytheon, and that’s an important part of our strategy.

We have done an Orbital ATK prior to joining Northrop Grumman, had been a merchant supplier to Raytheon and Lockheed. We got into agreements to support them on certain programs and we are very committed to uphold those agreements and continue to support them with our best and brightest people and technology.

As we look forward over the long-term, we certainly will look at every new opportunity as one that we would make a decision, is it right for us to pursue that as a prime or continue to have partnerships and work through the prime of Raytheon, Lockheed and perhaps others that might emerge in this space as well, or both, and offer capability to everyone who is choosing to pursue the marketplace.

And so those are decisions we’ll take one by one.

We are certainly not looking to take an aggressive stance in that marketplace, because as I said, it’s a growing market and it’s one that we feel is big enough for three parties to adequately play, and we want to make sure that our technology is getting into the hands of the war fighter and that we’re giving them the best capabilities in a timely fashion.

And sometimes it makes sense for us to work with our competitors to do that..

Thank you very much..

There’s time for one more question..

Thanks, Kathy..

Yes. Your final question is from the line of Joseph DeNardi with the Stifel Nicholas..

Yes, good afternoon. Ken, you talked about your confidence in the cash flow generation of the business and kind of the capital deployment strategy. You guys have one of the lowest dividend yields in the industry. Obviously there two components to that equation.

But can you talk about how you think about the dividend either as a percent of kind of free cash flow or total capital deployed, and whether you have a more ambitious plans for that going forward? Thank you..

Sure, I’d be happy to talk about that. Thanks, Joe. From a dividend perspective, I guess I’ll start with – we simply don’t chase yield and can’t chase yield. That being said, we’ve seen significant increases in our dividend every year for the last number of years. I think it’s been six years or so with double-digit increases. And in fact, two increases.

I guess, it was in 2018, two 10% increases or 10% plus increases in 2018. So we’ve been seeing a significant increase in our dividend per share. And I will say that you’re going to think of us as – certainly continue to think about what our future dividend increase would look like.

But again, that being said, we don’t – we don’t chase yield and it remains an important part of our capital deployment strategy. We’ve tended to think of it as kind of a range of 30% to 40% of our pension adjusted net earnings. And we’ve tended to be in the middle of the pack to our peers in terms of looking at our dividend based on that measure.

And so we think from a yield perspective, we may be a little bit low. But we think from a – again, looking at relative to our pension adjusted net earnings, that we’re pretty squarely in the range in terms of making sure that we have a competitive dividend..

Thank you..

Kathy, I would like to turn the call over to you for final remarks..

Thanks, Steve. I, once again, want to thank our team for their outstanding performance. Our business capture, our growing backlog, our fruitful investments, they continue to provide the opportunity for long-term value creation for our customers and our shareholders. I also want to thank all of you for joining us for the call today.

I hope that you enjoy the remainder of your summer, and I look forward to talking to you again in October. Natalia, that concludes our call..

Thank you, ladies and gentlemen. This concludes today’s conference call. You may now disconnect..