General Dynamics Corp (GD) — Q1 2019 Earnings Call Transcript

Thank you, Jamie, and good morning, everyone. Welcome to the General Dynamics' first quarter 2019 conference call. Any forward-looking statements made today represent our estimates regarding the company’s outlook. These estimates are subject to some risks and uncertainties. Additional information regarding these factors is contained in the company’s 10-K and 10-Q filings.

Thanks Howard and good morning all. Earlier today we reported earnings of $2.56 per diluted share and revenue just shy of $9.3 billion. Operating earnings of slightly over $1 billion and net income of $745 million. Revenue was up 23% against the first quarter of 2018, due in large part to the acquisition of CSRA. However, without CSRA, revenue was up an impressive 9.6% on a purely organic basis. In fact, there was organic revenue growth across all five operating segments. EPS of $2.56 was $0.14 better than consensus; it would appear that revenue was some $400 million higher than anticipated by the sell-side, and operating earnings were up about $40 million higher. Operating earnings of slightly over $1 billion were just ahead of the year-ago result despite modest declines at aerospace, marine, and combat systems. The result benefited from the combination of CSRA with GDIT. The operating margin of 10.9% in the quarter was good, though it did not compare favorably to last year's stellar first quarter of 13.4%, which was before the inclusion of amortization from the CSRA transaction. Net earnings were down $54 million over the same quarter in 2018. Higher interest expense and somewhat higher taxes were the cause of lower net income. It follows that earnings per share from continuing operations were $0.09 below the first quarter 2018, a 3% drop. Apart from the impressive revenue growth, an important part of the story in the quarter was order intake and growth in backlog. Total backlog grew to $69.2 billion, an increase of $1.34 billion compared to the end of last year. Excluding the impact of foreign exchange, the book-to-bill for the company was an impressive 1.2, broken down into 1.1 to 1 for defense and 1.4 to 1 for aerospace. So let me discuss each group and provide some color where appropriate. First, aerospace. Aerospace revenue of $2.2 billion was $450 million, or 22.7% ahead of the year-ago period. This is attributable in large part to the delivery of seven G500 in the quarter and a solid increase in service revenue. The moderately lower operating earnings were related to the mix shift at Gulfstream from the delivery of the G500. These planes carry the burden of the test program and retrofits as we previously advised. Margins on the aircraft will improve markedly through the year. At year-end, we had indicated that aerospace margins for the first two quarters would be in the mid-14% range, up somewhat from the 14.1% rate in the final period of 2018.

Thank you, Phebe, and good morning. Net interest expense in the quarter was $117 million versus $27 million in the first quarter of 2018. The increase in 2019 is due to the debt we issued to finance the acquisition of CSRA. We're also carrying more commercial paper than anticipated due to delayed payments on one of our large international vehicle programs in Canada. Our free cash flow of negative $976 million was impacted by the payment delays, and as we've discussed previously, this is a timing item. On the capital deployment front, capital expenditures of $181 million in the quarter were up about 75% from the year-ago quarter as we invest in our shipyards to support the significant growth that is on the horizon. We still expect this year to be the peak at approximately 3% of revenues and returning to the 2% range thereafter. In the quarter, we paid $268 million in dividends and we spent $86 million on the repurchase of 525,000 of our shares. We plan to acquire enough shares in 2019 to ensure there is no dilution from the exercise of employee stock options. Otherwise, we anticipate deploying the balance of our free cash flow this year to pay down our short-term borrowings. We ended the quarter with a cash balance of $673 million on the balance sheet and a net debt position of $12.9 billion. Our effective tax rate was 18.6% for the quarter, which is consistent with our full year tax rate guidance. As Phebe noted, order activity and backlog were a particularly strong story in the quarter, as four of our five segments posted a book-to-bill of 1 to 1 or greater, even as we grew almost 10% organically. On that note, I think it bears a reminder that not all companies report book-to-bill on the same basis. We calculate this measure based on the firm backlog as reported under Generally Accepted Accounting Principles, excluding the value associated with IDIQ contracts. That's of course most relevant to Mission Systems in GDIT, each of which had a book-to-bill of 1 to 1 or greater, even under the more conservative GAAP definition.

Thank you, Jason. As a reminder, we ask participants to ask one question and one follow-up so that everyone has a chance to participate. Jamie, would you please remind participants how to enter the queue.

Yes, good morning, thanks. Hi, I wanted to get a little better understanding on the margin trajectory at Gulfstream. You talked before in the last quarter about the lower margins at the beginning of the year and likely very attractive margins when you get out to Q4. Could you give us a sense of what's behind that trajectory? And are those higher margins at the end of the year the sort of normal margins that we might expect going forward beyond this year?

And as I said in my remarks, the margin rate is largely attributable to the mix. As we've talked about fairly frequently, that mix is driven by the increased deliveries on the G500, which carry lower margins in that first accounting lot, but we're going to be through that in the second quarter. And look, I think we've been quite transparent about this change in mix. We'll work our way through it, as we deliver more G500s and the G600s will enter into service, all with good margins. So when I think about it, our margins will improve throughout the year and as we go into next year, our performance will get better and better. As we hit full-rate production on the G500 and G600 and continue to come down our learning curves.

And then when you get out there in the G500 and G600 are mature, is it possible to give us a sense of how you might think about that between the G550 mature margins and G650 mature margins? Where would the G500 and G600 shakeout?

Well, the G650, nothing's going to come close to that for I think all the reasons you understand. But it is our expectation that the G500 and G600 will surpass the G450 and G550 peak margins. They are built in purpose-built facilities that are coming down straight line, and we have over that time continued to perfect our manufacturing processes. So when we are up, we're really running. I think we're going to be better than those two legacy airplanes.

Thanks so much. Good morning. Phebe, just to start off with Aerospace. You noted the good demand for the G650 in the quarter. Are you still going to stick with your plan to gradually ease G650 deliveries over time?

Yes. So a little bit this year, and then more in next year and the following year when G500s and G600s are in, as I say, full-rate production with good margins.

Okay. And then as a follow-up on GDIT, you noted a good book-to-bill in the quarter. How sustainable do you think this is? And what's the expected conversion of that book-to-bill to revenues over time?

Well, when we put something in firm backlog, it's pretty sure conversion into revenue. But let me give you a little bit of context to it. I think it helps to understand. So GDIT in the quarter at 1.1 to 1 book-to-bill, and over the last four quarters, as I mentioned in my remarks, they add 1 to 1. Now their win rate, they have demonstrated a win rate consecutively over those last four quarters between 70% and 75%. Against Dow's performance indicator, you've got a budget that is growing by 5%. So, I think this business is in very good stead for continued growth.

Hey. Good morning. Maybe a bigger, excuse me, a bigger strategic question. How are you thinking about Mission Systems? Right, I mean, their performance in the quarter was pretty good. And how do you think about growing that or it seems like it's sub-scale right now, right? Do you grow it? Do you sell it? What do you do with it, I mean, when you think about it?

So, given its portfolio, I don't believe that it's sub-scale. If you think about what they really are, they are systems integrators with a significant products business. They've got some long-term franchise programs, a number of them, and those programs are growing. So I like where they are; they've got some unique positioning, in fact, a best-in-class position in several areas, including network security, cyber protection, accuracy and positioning, navigation in a GPS environment, and integration of systems on the ballistic missile class submarines and the fire control system. So they assist in something. These are programs that they've had for a long time, all of which are on growth trajectories. So, I don't really see them as sub-scale. And again, their margins are really quite nice. This is a good operating leverage company. I think they play nicely in the space therein, and we're quite comfortable with this.

Okay, great. And then maybe just one follow-on in Aerospace. Can you say when the next available delivery slot for the G650 is?

Yes, I'm not getting into that anymore, so we're really not tracking it that way. We've got a whole lot of new airplanes coming on. So those individual metrics become a little less meaningful, but you need to think about what's really unusual and unique about the Gulfstream portfolio, as we have a family now of all brand new airplanes and when I say brand new, they are clean sheet, you know that better than anybody what that means, from scratch all new, nobody else has that, and that family is compelling, and we're seeing that in our consistent demand.

Yes, good morning. On the Gulfstream, Phebe, are we seeing the trend for orders continue strong in the second quarter here?

We're off to a good start, but your question raises a more significant issue regarding demand. I want to take this opportunity to consider demand more comprehensively. It's unwise to try to predict demand looking forward; it's easier to analyze it retrospectively, as long as we don't overlook key data. What does the data indicate? The market for Gulfstream airplanes has been positive over the past year during a time of increased deliveries. The book-to-bill ratio for this quarter was 1.5 to 1 for Gulfstream and nearly 1.1 to 1 over the last 12 months. This suggests we're experiencing solid demand without overheating. I see no data that indicates a shift in this trend. This is how we should frame our expectations regarding the demand environment as we progress through the year.

And then just a quick one on Marine. The revenues were somewhat less than I would have thought given the guidance of up 6% for the year and the margin was somewhat better. As we get increased revenues throughout the year, do we have the opportunity that the margin turns out to be higher than your 8.5%?

We will always strive for better margins, but it's important to remember that revenue depends on timing and mix. As we transition from Block III to Block IV, we have incorporated those margin changes, which is consistent with all our transitions between blocks. We consistently learn and adjust our bids, and each contract has similar profit targets. We also share some of that benefit appropriately. The U.S. Navy understands this as well. This means we must relentlessly and continuously improve our operating performance, which we have successfully done for 20 years. We will put in significant effort to enhance and speed up our learning on Block IV, but for now, we are comfortable with the guidance we provided.

Thanks. Good morning. Phebe, want to try and put a finer point on GDIT. I think publicly it's been said that while '18 and '19 have been relatively flat from a revenue standpoint, the '18 to 2020 kind of growth rate you're still looking for is mid-single digits. Is that correct?

Yes. And I don't think we've given you a lot of specificity about '20, but I tried to set some context to how to think about this growth profile. With those win rates, with the increasing budget and post-acquisition book-to-bill, we're in a very good place. So I look at this business as long-term good growth. In that budget it was about $100 billion, their addressable market budget is about $120 billion, a nearly 5% increase, which is pretty darn impressive. Good opportunities there.

Thanks. As a follow-up, Jason. Any quantification you can give on what the drag was in Q1 from the delay on the international side and any sort of idea around timing? I know you're expecting to reverse this year, but is this more of a second half item that you're looking for? Thanks.

Yes, so the amount that continued to push to the right, I think of it as roughly $1 billion, David, that's what we're talking about. It's lapsed over from last year and continues to push to the right.

And I think it's important to understand that these are negotiations between two sovereign powers that are progressing, but they're very, very sensitive, as all diplomatic negotiations are. Progress is good, but slow. We do anticipate it resolving this year.

Yes, thank you so much. So Phebe, I thought I heard you say that the Gulfstream 500 would move into the second production block in the second quarter. If that's the case, how come the margins aren't better than the first?

I think second half is what I said.

Second half, excuse.

Yes. So I mean that's the inference from us being through that first block, right, and we'll get through that in this quarter and get into the second lot in the second quarter. So, you're right.

Got it. So GDIT, obviously, you're looking for pretty good bookings. It's kind of we look around, there are several very large competitions for competitor programs in the network space, GSM-O and NextGen, how in terms of looking at your expected growth do you factor those? Because obviously you have other competitors and if you win, things are going to be a lot better, and if you lose, they won't be as good as you're projecting. So how do you factor them?

So if you think about us and you know us and you've known us for years. We are conservative when we look at opportunities. We give healthy discount rates, I think that are a good thing to do for internally for the business and the forecast and guidance that we issue reflects those discounted rates. So the beauty of a business with 7,000 contracts is that frankly no one is positive. But I'm comfortable that they'll win their fair share. That said, we've approached their pipeline looking through a conservative prism.

Yes, thanks. Good morning, Phebe. Phebe, first question on Combat I guess, you mentioned some very positive comments regarding the fiscal '20 funding levels for some of the core platforms. I guess maybe just in the context of longer-term growth, how you're thinking about how those programs are shaping up domestically? And then what some of the international opportunities that you're pursuing are for that could supplement that growth? Thanks.

The U.S. Army is in the process of recapitalizing its equipment after extensive use during recent conflicts. Due to a significant budget slowdown, they previously lacked the resources for this recapitalization, but they now have the means and are actively modernizing their current fleet while also exploring new platform developments. Our programs are tied to this existing fleet. Both the Stryker and Abrams vehicles have seen significant budget increases because the Army requires them. The Abrams remains an exceptional tank, and the newest version is far more advanced than earlier models, offering improved capabilities, survivability, and lethality, similar to enhancements seen in the Stryker. We believe these two flagship programs are positioned very strongly. We maintain close collaboration with our Army customer to understand their priorities and requirements, ensuring that we align our investments and explore innovative ways to support their goals. This applies not only to the mentioned core programs but also to new initiatives, where we assess feasibility, speed of execution, and costs. Building trust with the Army is crucial, as they need to rely on the accuracy of our estimates. We have a strong alignment with our Army customer, and I am quite pleased with the developments in our major vehicle programs. In the ammunition sector, we are experiencing growth, reporting a 10% increase this quarter. Our book-to-bill ratio in this area has been robust due to the rise in operational training demands, which drives higher requirements for munitions and armaments. Internationally, particularly in North America and countries such as the UK and Canada, we see opportunities for recapitalization, supported by our long-standing presence in these regions, as well as throughout NATO and Eastern Europe. The global security landscape is becoming more perilous, which increases the demand for our products. Our European Land Systems division is exploring various opportunities across former Soviet states and the Eastern Bloc, as well as other domestic areas. Threats are influencing funding and requirements, and unfortunately, we are navigating a world with heightened security risks.

Good morning and thank you for the time, everyone. Good quarter. Just a bigger picture question, I mean revenues were up I think 23% this quarter and profit was sort of flattish. How do we think about that inflection and profit growth in excess of revenue growth and timing of that and any maybe impediments to that that you see?

Let's divide the businesses into two main areas. In Aerospace, we've provided a comprehensive explanation of the margin compression. On the defense side, it's primarily about the mix. As we expand and take on new contracts while phasing out older ones, we face mix challenges, and currently, due to growth across all our defense sectors, we are experiencing some of that. This situation will continue to evolve throughout this year and into the future as we progress. One thing you can count on is our strong operational performance. We excel at enhancing what we can control, which is our own operations. Therefore, you can anticipate continued improvements over time.

Thanks. I appreciate that. And just one follow-up, I think you mentioned a $1 billion contract in Aerospace last quarter, was that booked?

I'm sorry, where?

Good morning Phebe, Jason, and Howard. I have two quick questions. First, regarding the certification of the G600, do you think there’s any risk involved considering the increased scrutiny on ODA and similar matters, especially in light of recent incidents in the industry? I would appreciate any insights you can provide on that and whether there is any risk to be aware of.

So, first the FAA, and as we're targeting late June, but they've got a pretty rigorous process, so that may slip a week or a couple of weeks or so, but I think importantly that does not impact our deliveries, which is really, I think, the key underlying question. We have not seen any new regulations or any new changes in the FAA oversight. So, we work very closely with them. Frankly, they're partners in ensuring that we deliver base airplanes efficiently, and so they've got an additional workload, but so far haven't really seen much of an impact.

Okay, great. And then just as a follow-up, I noted the comments you made in the prepared remarks around the cost progress on the missiles and the quality there, and obviously there's some uncertainty and risk when you took that work on. Is there, in your view, the opportunity to maybe favorably retire some of that risk that you had foreseen as you continue to make progress, and is this an indication maybe you're headed in that direction?

So cost is increasingly under control. The schedules, we de-risked a lot of the schedules. We're getting a lot of input from the manufacturing workforce, which will help us optimize our production, and again we're very, very good at manufacturing. So a lot of that risk is definitely behind us and it's going to get better.

Thanks very much and good morning. So I wanted to follow up on a question that Peter asked earlier about the Combat business and when we look at the budgets that have come out for Abrams over the past couple of years and what's being requested for 2020. It's kind of in the $2 billion-ish range, which seems like it's probably at least 2x, if not more than what the Abram sales were last year. I mean should we be expecting Abrams sales over the next couple of years to advance to this level?

You should expect them to advance. Think about it this way: for a while, during the period where the Army funding was seriously constrained, that tank plant was producing one tank a month. At the end of this year, we'll be rolling out 30 tanks a month by the end of this year. So that obviously will drive revenue growth, and that backlog increase translates 1 to 1 in revenue.

Is the impact of the shift towards domestic production on profitability primarily an issue with the Abrams, given that you've noted growth in Stryker as well as in the weapons and munitions sectors?

There are two factors to consider. One is the balance between domestic and international markets, and the other is the mix related to older contracts versus newer ones. As we increase production of Abrams, we must also focus on mobile protective firepower. We were selected as one of the two finalists for that project, so we need to navigate our learning curve effectively, which will contribute to our performance over time.

And operator, we'll just take one more question, please.

Thanks. Good morning. And Phebe, I'm curious, could you reflect on the certification process for the G500, G600 and how maybe it would influence your thinking of the next new aircraft? How you kind of publicly launch it versus privately launch it? Should we expect kind of timelines from public launch to anticipated EIS to maybe be a little bit shorter as you do more of the certification work behind the curtain?

Myles, I can't share specific details as that's proprietary information, but you can expect us to take lessons from everything we do. Our developmental and test programs have been extremely successful, and the airplanes are exceeding their design performance specifications. We will keep working closely with the FAA and continue to refine our processes. However, the way we announce information is sensitive.

Sure. So the balance between the two is basically the contract work in process. It's ongoing as you'd expect on any contract of this size. So that really is the delta there. And you'll see in the 10-Q we published later today that $1.9 billion that was reported at the end of the year is now up to $2.2 billion.

Operator. Thank you very much. Prior to the close, I'd like to first thank everybody for joining us today. And then secondarily, as a reminder, we refer you to our website for both the first quarter earnings release and our highlights presentation. If you have any additional questions, I can be reached at (703) 876-3117. Thank you very much.