General Dynamics Corp (GD) — Q2 2019 Earnings Call Transcript

Thank you, Rocco, and good morning, everyone. Welcome to the General Dynamics second 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. With that, it’s my pleasure to turn the call over to our Chairman and Chief Executive Officer, Phebe Novakovic.

Thank you, Howard, and good morning, everyone. As you can discern from our press release, we enjoyed a very good second quarter with revenue of $9.56 billion and net earnings of $806 million. We reported EPS at $2.77 per diluted share, $0.15 a share better than the year-ago quarter and $0.09 per share better than consensus. Compared to the year ago quarter, revenue was up $369 million or 4%. This is as reported, but organic growth was higher after taking into account the effect of divestitures at GDIT and the acquisition of Hawker Pacific. Remember that divestitures at GDIT provided some of more than $250 million per quarter in revenue. Net earnings of $806 million were up $20 million or 2.5% on a modest improvement of operating earnings and a lower effective tax rate, offset in part by higher interest expense. Sequentially, revenue was up $294 million or 3.2% and operating earnings were up $76 million or 7.5% on higher operating margins. With respect to consensus, revenue in the quarter was about $200 million more and the operating margin rate was 10 basis points higher than forecasted by the sell side. In short, $0.08 of the $0.09 beat was provided by stronger operating earnings. Let me turn very briefly to the first half of 2019 compared to the first half of 2018. Revenue was up $2.1 billion or 12.5% against the first half of 2018 driven by strong organic growth plus the acquisition of CSRA at the beginning of the second quarter last year. In other words, CSRA revenue was not reflected in the first quarter's results last year. On the other hand, operating earnings were up only $8 million, burdened by the amortization related to the CSRA acquisition. EPS was $0.06 better. In short, we had a very good second quarter, good sequential improvement, and a good first half. We are somewhat ahead of both our internal operating plan and external expectations. So, let me give you some perspective on the segment reporting for the quarter and for the half. I'll then ask Jason for some comments before I give you some insight into our outlook for the business and each segment for the remainder of the year.

Thank you, Phebe, and good morning. Our net interest expense in the quarter was $119 million versus $103 million in the second quarter of 2018. That brings the interest expense for the first half of the year to $236 million versus $130 million for the same period last year. 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 related to one of our large international vehicle programs in Canada. At this point we expect the interest expense for 2019 to be approximately $460 million. Our cash from operations of $291 million in the quarter was also impacted by these payment delays. As we've discussed previously this is a timing item. With respect to the outstanding receivable balance, we were recently told by the customer that we will receive considerable funding next month. We continue to expect to resolve the balance of the arrears by the end of the year. Assuming these outstanding payments come in this year, we still expect full year free cash flow conversion will be well in excess of 100% of net income. On the capital deployment front, capital expenditures were $181 million in the quarter or approximately 2% of revenues. Assuming receipt of the outstanding payments I just noted consistent with the timing I described, we still expect our capital expenditures to reach approximately 3% of revenues for the year, reflecting the investment in our shipyards to support the significant growth that's on the horizon. Our effective tax rate in the quarter was 18%, bringing the rate for the first half to 18.3% consistent with our expectations for the full year. In the quarter, we paid $295 million in dividends and we spent approximately $100 million on the repurchase of 575,000 of our shares. That brings the total for the first half to 1.1 million shares for $184 million. We plan to acquire enough shares in 2019 to ensure there is no dilution from the exercised 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 $702 million on the balance sheet and a net debt position of $13.2 billion. We expect to repay our outstanding commercial paper balance by the end of this year and our first tranche of fixed and floating rate notes matures in the second quarter of next year. I'll wrap up with a few points of color on the backlog and our order activity in the quarter. We had another solid quarter with respect to orders. We finished the quarter with a total backlog of $67.7 billion. That's up 2% over this time a year ago and the total potential contract value including options and IDIQ contracts was $102 billion, up 3% over a year ago. As Phebe mentioned, GDIT posted a particularly strong quarter with a book-to-bill of 1.24 times and I'll remind you that, that does not include over $2.5 billion in IDIQ awards in the quarter which as you know we don't include in backlog or our book-to-bill calculations.

Thanks Jason. So, turning to our outlook for the year. Let me provide our forecasts for the year for each segment compared to what we told you in January and then wrap it into our EPS guidance. For Aerospace, our guidance was to expect revenue of $9.7 billion, up $1.2 billion from 2018; operating earnings around $1.5 billion; and an operating margin around 15.5%. We now expect revenue of $9.95 billion with earnings of $1.525 billion with an operating margin of 15.3%. The increased revenue comes largely from increased preowned sales and modest mix shift. Earnings will be up on improved operating performance, but the margin rate will be diluted by preowned aircraft sales. For Combat Systems, our previous guidance was to expect revenue of $6.5 billion to $6.6 billion, up $260 million to $360 million from 2018 with operating earnings in the range of $965 million to $975 million. We now expect revenue of $6.8 billion and operating earnings of approximately $1 billion. The more revenues drives $25 million to $35 million and more operating earnings. For the Marine Group, we've previously guided to our revenue of $9 billion, margins of around 8.5%, and operating earnings of $770 million. We see no reason to change that guidance, although my bias would be very nominally lower. For Mission Systems, we've previously provided an outlook for this year of $4.8 billion to $4.9 billion with margins in the mid to high 13% range. This implied an operating earnings of around $660 million. We now anticipate revenue of $5 billion, operating earnings around $690 million, with operating margins of around 13.8%. For Information Technology, we guided to revenue of $8.3 billion with an operating margin of 7.5%. We now expect revenue of $8.5 billion and operating earnings of $630 million, with an operating margin of 7.4%, 10 basis points lower. So all of this sums to revenues for General Dynamics of about $39.2 billion and operating earnings of around $4.6 billion. Compared to our initial guidance, we will have both higher revenue and operating earnings. This permits us to increase our EPS outlook from a range of $11.60 to $11.70 to a range of $11.85 to $11.90. As for the quarterly progression, it appears to us that the third quarter will be $0.30 better than the second quarter.

Thanks, Phebe. As a reminder, we ask participants to ask one question and one follow-up. So, that everyone has a chance to participate. Rocco, could you please remind participants how to enter the queue?

Thanks so much. Good morning.

Good morning.

Phebe, the Aerospace division, one of your peers noted that their customers took a bit of a strike in May and June with concerns over the economy and tariffs and I was wondering if you saw anything like that at Gulfstream?

No.

That was pretty straightforward.

Look we have continued to have nice order activity. Our pipeline remains robust. As I think I have explained to many of you before, you need to look at the business aviation market, not only by cabin size but really by OEM because our experience in the marketplace is very different from others. So we continue to have good order activity throughout each of the months in the quarter.

That’s great. That’s very helpful. Thank you.

Yeah, good morning.

Hi, Ron.

Just to follow on to Rob's question. I mean, can you kind of walk through the demand environment you're seeing across the different products you have at Gulfstream 650, 600, 500, 280?

Sure. So the 650 continues to have very solid demand. I think by the end of this quarter we had 370 in service. It continues to have performance characteristics unmatched by anyone else any other aircraft and it continues to enjoy some very nice solid demand. The 600 has had very good demand. We suspect as we saw that the 500 when we start delivering these airplanes that is the catalyst for incremental demand increases and I have every confidence that that will also increase. The 500 continues nicely and the 280 has had good sales but a little bit more episodic; that end of the market tends to be that way. But on our big key platforms, airplanes, we’ve continued to have good activity.

And then as a follow-on question, have you seen any blowback in the Chinese market regarding the potential sale of Abrams to Taiwan? Because there were some stuff in the Chinese press about it. I'm not sure if it's just kind of press noise or if there's some reality there?

As far as I know, no tank sales have actually occurred. But let me remind everyone how this works. This is an FMS case or any FMS case. The U.S. Army buys our tanks and sells them to other foreign nations in this case potentially Taiwan. I'd say that we've had fairly muted demand in that market for a while now, and I suspect that tariffs have had some dampening effect but the pipeline is increasingly active and we've been quite comfortable on where we are.

Great. Thank you very much.

Thanks. Good morning.

Hi, David.

Phebe, so on the G500 it looks like deliveries in the quarter based on the 21 that you said have been delivered so far. It looks like deliveries were pretty light in the quarter on G500. Maybe I expected the margin to be better because of that. Can you just talk about that and if you’re through the first block that's below margin G500 deliveries at this point?

We had a bit of a catch-up in the first quarter right after the 2018 certification. This is merely a timing issue, and we are continuing to improve as we gain experience. Our margin performance is improving with each airplane that comes down the line. Currently, this is just a timing issue where we faced a backlog in the first quarter, but we have overcome that and are now entering a steady state.

Okay. And then for my follow-up, on GDIT, it looks like based on your updated guidance, you're still expecting organically, ex the divestitures, relatively flat in the second half of the year. When do we start to see this strong booking rate that you've highlighted come through in terms of actual organic growth of that business? Thanks.

By 2020, as we said before, this is in a transition year for us and a positioning for growth year and all of the indicators of growth are there. So, we are pretty confident that next year is going to realize some of those increased backlog.

Hello, thanks very much and good morning.

Morning.

I just want to ask a little bit about the cadence of EPS not that it matters that much, I mean the guidance is out, but just in terms of what you had thought in January has kind of a very heavy fourth quarter and it seems like the EPS that had been in the second half cadence back in January, did some of that show up in the first half?

Somewhat, but our guidance is really reflective of the situation. The key point behind the update in the guidance is that we are seeing increased revenue with similar margin performance, which leads to higher earnings. When we provide our mid-year update, it is based on thorough operational reviews, and we have carefully considered guidance that examines all risks and opportunities. We aim to narrow our range and provide a certain level of precision, but the main takeaway is that we are experiencing more revenue and higher earnings.

Okay, great. And just in Combat, in terms of if there were kind of specific platforms that drove the increase in the guide and, kind of, was there a meaningful amount of FX that you had to offset on the P&L just to be able to raise the guide by that $30 million?

Not on the P&L with respect to FX. This is simply continuing to come down our learning curves on the domestic programs that we now have and are increasing and then it's the velocity of the domestic program vehicles as we increase our manufacturing capacity. So that's really the undergirding. It's all a story about domestic right now in the U.S. Army.

Thank you very much.

Hey, good morning, everyone.

Hi, Noah.

Jason, regarding the free cash flow, could you help us understand the transition from this year to next year? I recall you mentioning that the Canadian labs payments in the second half of this year will result in a 100% conversion of free cash to net income for this year. This suggests that without those payments, the conversion would be below 100%. Given that capital expenditures are still a factor and considering other working capital changes, can you guide us on the connection between 2019 and 2020? Or is it straightforward that after this year, we will see a clean transition to 100% conversion?

If we focus on catching up with the arrears in the international program this year, we have indicated that we believe this year and the following years will see a conversion rate between 90% and 100%, remaining fairly steady, with some fluctuations due to capital expenditures and similar factors. The current anomaly is related to a timing issue that also affected us last year. To clarify our outlook for this year, if we manage to fully catch up, we anticipate exceeding 100% conversion. This should clarify some of the calculations you had in mind. Looking beyond this year, we expect to maintain a consistent conversion rate in the 90% to 100% range annually, with some fluctuations due to capital expenditures and other investments.

Got it. And then Phebe just going back to Gulfstream, can you speak to what pricing has been like in your recent order activity, better, worse or the same and what that means for margin improvement in the business going forward?

Well, as you can imagine, we're very sensitive about discussing pricing, but you can well imagine that we continue to enjoy the pricing that we've seen recently in our business and on each of our platforms.

Yeah thanks. Good morning, Phebe and Jason.

Hi.

Good morning.

Phebe, regarding GDIT, it's encouraging to hear that the integration is progressing ahead of schedule. Considering the 1.2 book-to-bill ratio we've observed this quarter, would you say this reflects an increase in market share for you, or is it primarily driven by the current spending environment? Could you share some insights on what you're experiencing? Thank you.

For those who have been with us for a while, we don't focus on tracking market share, as that can often lead to misguided efforts. It's possible to have a significant share and still face financial difficulties. Our main focus is on the strength of our pipeline and our win rates, which have been around 74% to 75% for recompetes and approximately 90% for other opportunities since the acquisition. We've maintained a strong book-to-bill ratio of at least 1:1 since then and are building a backlog of programs that we believe we can execute effectively and efficiently. GDIT is fundamentally a people-centric business, and attracting talent relies on fostering a superior culture with clear career development paths and engaging work. In my view, we've excelled in this area, which I believe supports the impressive performance exhibited by our management team since the acquisition. To give you a sense of scale, in the first half of the year, we submitted nearly $24 billion in proposals, surpassing all submissions from 2018. For the latter half of the year, we're anticipating around $27 billion in proposals. In the second quarter alone, we submitted about 350 proposals, totaling approximately 650 in the first half. This demonstrates the necessary execution and submission velocity we possess. To achieve our resulting win rate, we require a robust management team, supported by the culture and talent I just mentioned. Overall, I am very pleased with our current standing and performance with GDIT.

Appreciate all the color. Thanks, Phebe.

Yes. Thank you very much. So Phebe, could you give us some color in terms of the lead times at Gulfstream particularly for the G650 and 280?

As we transition to new aircraft, we are no longer tracking individual plane lead times. However, I can assure you that all of our wait times are comfortably within the range of 1 year to 18 months across our portfolio. I feel positive about that. It's important to note that we have continued to perform well and maintain reasonable lead times for both our legacy and new airplanes. We're effectively managing our orders and the demand, and I believe we are doing quite well.

Thank you. Can you update us on the number of bids awaiting decision for the remainder of the year at GDIT? Additionally, could you provide some insights on potential pursuits like GSMO and next gen?

So I don't actually know the timing and award decisions, given all the input that is really idiosyncratic to the individual customer, but I think one of the reasons I wanted to share with you the velocity of contracts and the enormity of the velocity of proposals and the enormity of the proposals, to give you a sense that we do not track and I don't think about this business in terms of any particular pursuits. And many of the pursuits you happen to mention are in our competitive space, so we’re certainly not going to talk about that. But I think that both the size and velocity of the submissions give you a real sense of this is a big business with a lot of moving parts. And frankly I don't worry about any one particular program.

Terrific. Thank you very much.

Hello, Myles?

Sorry about that. Good morning. Jason I was wondering if you could first maybe clarify on the payment you expected next month or just give a rough size of the burden at hand you have there. Would you get to full conversion for the year if that one came through?

I think we've shared everything we can about our current status on that program. As you can imagine, these discussions are quite sensitive, and we've indicated that we're making good progress, so let's leave it at that.

Okay. Maybe a follow-up then.

Yes, go ahead.

The Marine Group, Phebe, you mentioned on the Marine Group that you weren’t changing the guidance that your bias was nominally lower, I just wanted to clarify was that lower on the margin or on the topline?

I think I mentioned very nominally lower. I'm operating in a large business with many moving parts. I'm particularly sensitive, especially when we have new starts, and we have several new projects starting at our West Coast shipyard. Additionally, depending on the Navy's requirements, we might see extra materials coming in this year, which typically carry lower margins. Therefore, I'm at the stage where, very nominally, I want to emphasize that we lack as much clarity as we usually do in any given quarter, and that's why I provided that mild caveat.

Yes, I know. I was just clarifying because it looked like revenue was running ahead, so that makes sense on the margin. Thanks Phebe.

Hey, good morning guys. Phebe what's your view as you look at this two-year budget deal that's kind of shaped up this week for 2021. How do you think about the Navy’s ability to afford the Columbia class or for the potential for that program to crowd out other ship priorities or other programs for – if we are going to go into a flattening, kind of, environment?

It's certainly encouraging to see some clarity in our political landscape right now. Let’s discuss Columbia for a moment. Columbia is a national priority, and I believe funding will be allocated for it. There are various budgetary approaches to achieve this, and I think the U.S. Congress and our customers are exploring different ways to ensure healthy budgeting. In the past, we set up a separate account for projects like Ohio in the 80s, which could be an option again. Therefore, I'm not overly concerned about Columbia taking resources away from other programs. The Navy has a clear need to modernize its fleet and increase the number of ships. There's a consensus in Washington across the political spectrum that recognizes the necessity of replacing aging vessels. I am confident that the Department of Defense will collaborate with Congress to find the right funding strategies to address your concerns.

Got it. Just as a follow-up, what's the reason behind the higher pre-owned volumes this year at Gulfstream? Is it just a really active market? Or maybe this year is just an anomaly in terms of initial 600 customers or something like that?

There is nothing in particular. On occasion we'll have a bit more pre-owned but it signifies nothing.

Hey. Good morning, guys.

Hi, Carter.

Good morning.

I have a quick clarification and question. My notes indicate that Maximus had a $900 million impact on the organic calculation, but I believe you mentioned 250 plus. Phebe, could you please clarify that for us? Additionally, now that you have received certification at Aerospace for the two new airplanes, do you expect R&D to be more stable? I understand there was some year-over-year variability due to a comparison in the quarter, but should we anticipate more consistency going forward than what we've experienced in the last several quarters?

Let's address that in reverse order. As we transition the test airplanes from the test program to the customer set, we will see a reduction in R&D. We maintain a consistent level of R&D in our business, which we believe is appropriate. Therefore, we anticipate some decline. However, we will continue to engage in a range of active R&D activities with Gulfstream.

And then Carter on the first half of your question, I think, your inference was correct on the scale of the business that we divested to Maximus. There were however in the last 12 months or so a couple of other smaller divestitures we did in the IT portfolio. We had a small commercial health care divestiture. We had a next-generation 911 supportive business. When you add all those up the total annualized revenues were somewhere slightly in excess of $1 billion so that was to Phebe's point, a roughly $250 million a quarter impact.

Okay. That’s great. Thanks for the clarification.

And Rocco this will be our last question coming up now please.

Hey, thank you for the timing. Good morning.

Good morning.

Phebe in terms of supporting that GDIT ramp into 2020, can you give us some color on how the personal recruiting site is going? I know it's a very important part of the people business.

The management teams have come together effectively. We integrated leaders from both legacy businesses into a unified team throughout the initial three quarters. During this acquisition and integration, we retained nearly all of the key leaders we aimed to keep. I believe we kept every leader we wanted. Additionally, we are seeing a decrease in staff turnover. This signals to me that we are successfully building a cohesive team at GDIT across their leadership that can sustain a long-term, robust, and successful business. I am very pleased with the energy, cohesion, and culture they have established, which is truly impressive.

Great, thanks. And then just thinking about that pickup. I mean, some peers in the market tend to talk about mid single digit organic growth. I know market share is not as important to you guys, but is that how we should think about the potential and should EBITDA growth accelerate in line with sales growth in 2020?

Well, I think we're growing about 3% this year and we'll see some nice growth in 2020. But beyond that we're not going to piecemeal 2020 at this point. We'll give you our 2020 estimate and outlook and detailed view of the business as we always do in the fourth quarter call after our fall review where we do in-depth analyses and bottom up operations reviews of each one of our businesses and we'll let you know then. Fair enough?

That’s right. Thank you.

You did. Thank you.

And thank you for joining our call today. As a reminder please refer to the General Dynamics website for the second quarter earnings release and highlights presentation, which will now contain our earnings outlook to the balance of the year. If you have any additional questions I can be reached at 703-876-3117. Thank you very much.