General Dynamics Corporation (GD) Earnings Call Transcript & Summary

Good morning, everyone. We're going to go ahead and get started. We're pleased to have General Dynamics again here with us this year. We have Jason Aiken, the Chief Financial Officer, again this year. Thanks for your continued support of the Barclays conference. I'm David Strauss, aerospace and defense.

So I'm going to kick it off, turn it over to Jason. Wanted to ask you a little bit about the fiscal '21 defense budget that we just got, some moving pieces in and around Virginia Class and Abrams and Stryker. Maybe give us your take on how you fared in the '21 budget request.

Sure. First of all, thanks for having me again this year. Appreciate the opportunity. Before I get started, I should, of course, make the standard statement about forward-looking statements that will be made here today come with the typical risks and uncertainties, and you can read more about that, of course, on our 10-Ks and 10-Qs. But with that out of the way, as it relates to the budget, I think when you think about the context of a flattening budget environment, and with that as context, I think we feel very good about where we've come out. And that this is overall a budget that is supportive of the growth expectations that we have. I think, importantly, all of our franchise programs are fully funded in this budget, and that's an important takeaway. You pointed to a couple -- or you noted a couple of nuances that I think people are focused on. On the one hand, Abrams, a little bit of a reduction there in the Abrams funding from what had been nicely elevated levels over a couple of years. So I think when you take in the context of what we've seen over the past couple of years, and we're still working off some of that and the increases we saw in the '20 budget, and you take that together with what we've got in '21 and what we expect beyond that remains supportive of the production ramp that we're still working our way through on Abrams through this year and next year. More importantly, perhaps, I think people are -- or on a larger scale, people are focused on the one boat from a Virginia class program standpoint. Really, the way I think to think about that is if you think about the Block V contract award that we just had late last year, that was structured with 9 firm boats and an option for the 10th boat, and that was sort of used in the budgeting context this year when they're funding at Columbia and as well as the Virginia program. They took advantage of that optionality to fund the one Virginia this year, and they've still got the opportunity to exercise that option on the additional boat in later year. So I don't think that -- in fact, I know that doesn't have any significant impact on us. That happens to be a Newport News delivery boat, so even less perturbation in terms of our yard up in Rhode Island and Connecticut. But overall, again, I think a budget that we're pleased with, supportive of our growth. And I think the last point I'd make is when you're in the context of an environment of budgets where you're having to make trade-offs, one of the [indiscernible] you can have, I think, in that context is strong performing programs. When you think about where the puts and takes are going to be made, and who're going to be the bill payers, our emphasis, as always, has been on operational excellence and making sure that our programs are performing in a way that they're going to get the support that we've seen and that we expect to continue. And so we feel good about our position in that regard.

Okay. I want to quickly touch on each of the businesses, if we can. Maybe since we talked to their mainly about shipbuilding and the sub businesses -- sub programs, maybe talk about Columbia and where we are in that ramp process, both from maybe a capital investment standpoint and then how that program is going to drive growth over the course of the next several years when the first -- when you start building the first boat and kind of how it progresses from where we are today.

So the program continues on schedule and making good progress. In terms of the capital investment, we've talked about the multiyear investment we're making there in those shipyards. Based on some cash flow timing issues that we've talked about, and I'm sure we'll talk about a little bit more today, some of that CapEx investment is pushed a little to the right out of our prudent management of our cash flow situation. So we had previously expected the capital expenditure on that program to peak last year. It will end up peaking this year and then tail down over the next 3, 4 years after that. So that's on sort of the investment side. When you look the activity on the program, starting with the engineering and design effort, the design of the ship is complete, and the detailed drawing to support the construction of that -- those initial boats are, I think, they'll be in the range of 85% complete by the time we start construction. So to give you some perspective on where we've been historically, when the Virginia program started construction, I think we were 40% complete with those detailed sort of deck plate drawing. So significant risk reduction in terms of the progress made there. As you're aware, we're anticipating signing the first construction contract for the first boats in the Columbia later this year by the fourth quarter, and starting formal construction by the fourth quarter of this year. So we've had early preconstruction activities going on for some time now, but the more significant ramp in construction will start toward the fourth quarter of this year. What that will mean over time is the construction will ramp over, call it, '21, '22, '23. And as the engineering and design effort wanes, as we complete those drawings, you'll see a little bit of an offset there. So modest growth on the Columbia program, net-net over the next, call it, 2, 3, 4 years. Then once you normalize that, the engineering and design is done, you get past 2023, you start to see the more significant ramp over the next decade. And it will be significant ramp to the point that electric boat more than doubles in size over that period of time as Columbia construction ramps. So last point I'd make is the net increase we really expect to see in the shipyard part of the business, specifically the submarine programs over the next 2, 3 years is really on the Virginia side with the Block V contract, and that really comes in significant part with the Virginia payload module, that 25% increase in the ship based on that additional module. And of course, that's all electric boat performing network. So that's, hence, a reason for some meaningful step-up in growth in the midterm here, call it, over the next 3, 4 years.

Okay. Let's switch gears and talk about Combat. Maybe touch on how you see the domestic business over the next couple of years relative to international and then what that means for the margin profile. So that used to be -- Combat had been running consistently above 15% in terms of margins. They've dipped down a little bit. How do you see margins progressing within that mix of business between domestic and international over the next couple of years?

Yes. This is a business that's been quite agile, I think, in how it's handled some volatility in its demand signals, both domestically and internationally over time. If you go back a decade ago, we were in a period of 2 hot wars, and we were 80-plus percent dependent on U.S. domestic ground forces budgets and contract activity. That came down precipitously so -- to the point that by 2013, 2014, we were looking more at a 60 -- maybe 55-45, even 60-40 international slant toward the base of business. And to your point, that, plus the business, is focused on its cyclical responsibilities and managing its cost. We were able to get the margins up into the 15, even mid-15 and higher percent margin rate. What we're seeing now is that most of the growth in last year and the coming couple of years is coming out of the U.S. recapitalization efforts. So we'll end up closer to a 60-40 U.S.-international split as a result of that transition. And of course, that does bring a little bit of a different margin mix. So we see ourselves in the 14% to mid-14% range as opposed to the 15% to mid-15% range. I think that's quite natural. But I would say that while that's a reason for that margin shift, we like to say it's not an excuse. And so we continue to drive this -- not just this business, but all our businesses to focus on margins. And we absolutely expect them to optimize within that context. And we're going to bring every bit of margin we can out of those programs even as the mix shifts a little bit more toward U.S.

Touch on GDIT. So talk about CSRA, how that business has been performing, some of the legacy programs that have rolled off, how much of a headwind that's been, how that headwind looks maybe in '20 and '21, when you expect that business to return to growth. Obviously, we're seeing the peer group growing mid-single digits. So in the context of that, maybe touch on how GDIT is doing.

Yes, the revenue story on GDIT is one of, obviously, a lot of interest out there, and for good reason, I think. And we've talked a bit about some of the factors behind that. When you think about when we first completed the acquisition in that first year 2018 of the integration, we certainly experienced what would not be unexpected in terms of a large-size integration. We had some transition there that included some legacy programs that rolled off. We frankly lost a couple of recompetes. We, frankly, won some new business that starts up and replaces that. But the timing of that is not exactly a one-for-one trade-off. So you see a little bit of a headwind in the near term with some longer-term opportunity there as those newer programs roll in. The other factor that we've seen that we've talked somewhat about is in this environment, which is an incredibly rich opportunity set environment, when you look at the tens of billions of dollars of procurements that are out there that we're competing for, that is an incredibly rich opportunity set. And of course, part of the reason that we found this acquisition and the combination of these businesses to be compelling. But ironically, perhaps, because the procurements are becoming higher stakes for everybody involved, these are $500 million, $1 billion-plus type opportunities, we are seeing more and more protest activity because they're higher consequence, and we're seeing more delays in the ultimate adjudication of those programs to award the ultimate contract award and subsequent performance on those contracts. And to give you a data point on that, if you look just at the contracts that we're up competing for, that we're interested in, in our pipeline, we ended 2018 with roughly $10 billion of contract awards that our customers had scheduled to award, not necessarily that we would have gotten 100% of, but that we were playing for and that our customers have scheduled to award. By the end of 2018, there's a backlog of roughly $10 billion. By the end of 2019, that had grown to $20 billion. So we're seeing some of that impact us from a headwind standpoint. That's a timing thing, and we're confident that will work itself out. And to that point, when you look at our backlog and our win rates, the order activity, backlog for that business was up, I think, in the range of 12-plus percent last year. That will manifest itself in growth. But from a timing standpoint, we have to acknowledge it's coming a little slower than we anticipated. And one other point I'd make is don't underestimate the impact of the meaningful portfolio shaping that has been -- has undertaken in the context of the combination of those 2 large businesses. I think most are aware that we sold, in the course of probably 3 or 4 transactions, roughly $1 billion of annual revenue. In the aftermath of that acquisition, probably a little bit less. Well understood is that last year, GDIT deliberately exited -- strategically exited 2 lines of business that they deemed to be not core. They weren't a leader and didn't have a great opportunity to get the margin profile they wanted and the growth they wanted. So that represented $250 million in annualized sales that was just sort of left behind. So you normalize for that and, really, on a same-store sales sort of basis, they're up about 3% to 4% year-over-year. But the fact is that's a reality. They did exit that. And as a result, they're on the flatter side this year. And we've got to show the growth coming ahead. And to the point I made earlier, I think when you see the win rate, 75-plus percent win rate, strong 90-plus percent recompete rate, 12% year-over-year backlog growth, and they continue to do well in order activity as we enter this year, we fully expect the revenue to come. It's just we wanted to come as soon as everybody else does, and we still believe the long-term value proposition for that combination is absolutely solid. And we have a lot of conviction behind it.

What about the margin profile of that business? I know you have pretty close to industry-leading EBITDA margins in that business. But I would have thought, even with relatively flattish revenues, given the synergies that maybe we would have seen a little bit of uplift in terms of the margins there.

Yes. The reported operating margins are creeping up 10, 20 basis points a year at a time. There's a lot of factors in a business that's this large and complex, as you'd imagine, affecting that. Obviously, the -- this industry tends to focus sort of apples-to-apples on an EBITDA margin level, as you pointed out. When you look pre-acquisition, I think CSRA was in the 15-ish percent range. GDIT was more in the 9% range. When you look at where they came together in 2018, they were 12%, so right down the dead center, which makes a lot of sense. The competing factors there are the amortization burden, and that's coming down. The synergies, which are, in fact, ahead of schedule relative to what we expected, and they're coming in nicely. And so that's actually a solid contributor into margin performance. Offsetting that, as we've talked about since the outset of the acquisition, was we expected, from a mix perspective, to have about 150 basis points of contraction in the legacy CSRA contract base. So you put all those puts and takes together, and what are we seeing in terms of that combined EBITDA? As I mentioned, we came into 2018 with a blended 12% rate. 2019 was up 60 basis points to 12.6%, and we expect that to get closer to, if not exceed, 13% in 2020. So I think when you look at it on that basis, we are seeing some nice progression. That's -- again, that's something we're never going to say victory is declared there, I expect to see both the EBITDA margins continue to improve as well as the core reported underlying operating margin improve.

Last business, touch on Aerospace. So a couple of questions there. Let's start with the 650, how that feathers down from here, I guess, over the next -- in '20 and '21 and what that means for margins. Do you actually see lower margins as a result of lower volumes on the 650?

Okay. So as you mentioned, production, we've -- as I think most are aware at this point, we had 650 production at an elevated level in the '15, '16, '17 time frame, basically covering that transition period that we've talked about on 450/550 to the 500 and 600. And as you quite rightly point out, we always anticipated and we're continue to be on a plan to bring down the 650 production to what we expect to be a long-term sustainable production and delivery rate relative to annual order demand. We started that production downtick in '19, as expected, and that will continue modestly in '20 and '21, and that should level out by 2022. So that will bring down that production again to what we see as a more normal year-to-year balance of production and order demand. And so that's all consistent with our prior expectations. As it relates to margins, I think 2 aspects to your question. Number one, are there reduced margins on 650 production as a result of reduced production activity? And I think the short answer to that is no, not in any significant way. The supply chain agreements that we have are by airframe over a significant period of time, a significant number of units. I don't want to get into specifics around that. But the point of that is annual increases and decreases in production rates don't necessarily drive incremental or decremental margin opportunity within the context of those broader supply agreements. What does happen, though, as you would quite expect, that's our -- I think it's pretty clear, that's our highest-performing margin program. And when you bring the rate down, that's going to have a decremental margin impact on the overall margin profile of the group. So obviously, it's our responsibility and our intent to work the margins on the new products, the 500 and 600 specifically, to come down those learning curves and more than offset the impact of the reduced aggregate margins from the 650. And that's absolutely what we're seeing and what we're intending.

Touch on the 700. I think you got initial orders in the fourth quarter, the activity that you're seeing. How has it been? And what is the customer profile? Obviously, the concern is that 700 cannibalizes the 650. So touch on what you're seeing from a customer standpoint, if you're seeing orders that would augment the 650 or cannibalize the 650.

Yes, I think, first and foremost, the response in the market has been quite robust and very exciting, and that's really encouraging. And we had -- did get a good number of orders in the fourth quarter, and that interest continues here in the early part of the New Year. As it relates to where that airplane sits in the market segments and how it impacts the 650, our thesis was that that airplane -- first of all, to be absolutely clear, that airplane is not a replacement of the 650. The 650 continues in production based on all the cadence that we just talked about over the last few minutes. The 700 sits in an adjacent market space and serves a different mission. And as I think you've heard Phebe talk about that announcement of that airplane, the clarity around what it is and the mission that it supports has actually helped firm up people's understanding of where the 650 sits in the market. And we've seen that in terms of that fourth quarter order activity. We, obviously, had a very strong fourth quarter at Gulfstream in terms of orders. And part of that is people who were sitting sort of on the sideline speculating, "We know GD is doing something with Gulfstream. We think it might be a 650 replacement. We're going to wait and see how this shapes up." And in fact, when they've seen what this new airplane is, how it compares to the 650 and where it is on those market segments, it's actually freed some people up to say, "Okay. Now I understand the future." And they've come off the sideline and ordered 650s. So we had more 650 orders in 2019 than we had in 2018, and absolutely supportive of those sort of what I referred to earlier as sustainable year-to-year production and delivery versus order and demand signals. So look, they'll sit together. I think the customer profile for the 650 continues to be our bread-and-butter market of -- to think of the North American European Fortune 500-type customers. The 700 is a smaller market, I believe, than the 650. Obviously, we've just delivered, we announced our 400 G650, so the 700 sits. And probably, if you think of the pyramid of demand, with the value of the airplane on one axis and the number of available buyers on the other, it's a somewhat of a smaller market. And it tends -- but a robust market and, as I mentioned, robust interest out of the gate and one that tends to lean more toward, perhaps, international, more towards high net worth individuals, those types of buyers as opposed to sort of that bread and butter Fortune 500-type mix.

Last one on Aerospace. So I think for a while, we've had this framework as you go through the various product transitions that we should think about EBIT relatively flat around $1.5 billion. R&D is moving around. Where are we today in that transition? So I think this year, you've forecasted revenue up, margins relatively flattish, EBITDA up a little bit. How should we think about heading in over the course of the next couple of years with the 650 coming down, the 700 coming in? I assume R&D kind of stable, 500, 600 ramp. I mean there's just a lot of moving pieces here.

A lot of moving parts. Yes, I appreciate. That's important to recognize that there are a lot of moving parts. It's not just one factor at play here. And I think to your point, the 2 real driving questions that have been on people's minds are, "Where is the margin story? When do you return to high-teens margins? And what's the earnings curve look like when you go from modest improvements to more meaningful improvements?" And I think those are fair questions. When you look back, '20 -- I think when you look at 2018, think of 2018 was the trough year from an earnings perspective. And then specifically, the fourth quarter of 2018 was the trough period for -- from a margin perspective. When you look at the margins, we saw a nice sequential margin expansion every quarter from fourth quarter of '18 through first, second, third, fourth quarter of '19. So right along the trajectory. In fact, a little bit better than we had expected. We expect to see, from an annualized basis, margins continue to expand modestly this year. But part of that is we've described a similar curve where we'll start out a little lower in the year, closer to the 14% range, but end the year in the fourth quarter, essentially, in the 18% range. So this question of when are you going to get back to the high-teens margins, we'll see that by the fourth quarter roughly of this year. And then we'll -- there's going to be quarterly perturbations in margins for all the reasons you sort of articulated. A lot of moving parts in this business, but we'll be at and in and around and moving toward continuing to drive these margins on a more sustainable basis toward that high-teens range. The second part of the question around the curve on earnings is, as I mentioned, '18 was the trough year. We saw a modest, call it, 3% increase in '19. We'll see a modest, call it, 3% increase in '20. And our commitment fundamentally is that the earnings dollars and that the margin rate at Aerospace will continue to uptick year-on-year as we look out. That's what's going to happen. Now this -- the inflection of that curve, I think we have to be transparent, acknowledge some of what the moving parts that are going on in there. And part of that is for -- in part due to the regulatory environment and the certification process, in part due to some well understood and publicized supply chain issues. We saw some of the certifications and entry into service and the ramp-up of some of those products pushed out a little bit, right? And so what you're seeing in terms of the margin lift and the earnings lift is the ramp-up in those products is pushed -- was pushed out a little bit. So the dilutive effect of them pushed out a little bit, so the curve and the earnings shifts a little bit accordingly. But I think, again, the bottom line long-term commitment is from '18 to '19 to '20 and beyond, year-over-year, margin, earnings growth out of Gulfstream and Aerospace group.

Yes. Taking it back to the high level, free cash flow, the conversion there. So obviously, less than 100% for a couple of years. Now the moving pieces in '20 between Gulfstream and the unbilled receivable on the international side, how that's going to play out in '20 and then beyond, the puts and takes on the free cash flow conversion this year at 85% to 90% and then where we go from here.

So you'll recall, we had some cash flow headwinds dating back to, call it, 2015, 2016 time frame. That was some of the perturbations of large deposits and supply chain payments on some international programs back then. And we expect it to return back to our typical cadence of 100-ish percent cash conversion in '17 and beyond. And in fact, in 2017, we saw that. We were well in excess of 100% free cash flow, net income conversion in '17. And then come 2018, we started to see some of the delays in working capital. Working capital buildup is a result of some of the delays on the international vehicle programs. So that kept us below 100% in '18, below 100% in '19. Where we are as we look at 2020 is a couple of different factors here. On the working capital front, we've stabilized the situation. So we don't expect to see further deterioration in working capital. We've got greater clarity around the payments and the payment structure on the international side of things. And so the payments we will have received and will receive this year will match roughly the production activity that we have on that program. So stabilizing the OWC and unbilled receivables on that side of the business. The impacts that are driving the conversion rate into the 85% to 90% range versus, call it, 95% to 100% range this year are really more around the other side of the impact, which is the capital spend. I mentioned before how we had planned 2019 to be the peak given that we had some of these uncertainties on the cash flow front over the course of that year. We quite prudently, and as you would expect, push some of that to the right, so the increased CapEx this year keeps that number down a little bit. That's about half of the impact, call it, $200 million. And then we also have a little bit of an increased pension contribution this year. That's essentially the other half, so another couple of hundred million. If you take those 2 perturbations out and normalize for that, the rest of the business this year is running at essentially 95% to 100% cash conversion. The good news is, as you look ahead into '21, '22, '23, we start to more meaningfully unwind that OWC on the international front. That's a much more predictable routine level of payment. We have great clarity and visibility around that, so we should see that turn. And likewise, don't forget that at Gulfstream, as part of this investment and this buildup and the opportunity of these new products, we had a lot of test airplanes as part of that. You've got the 500, the 600, the 700. They each have 5 test airplanes. You can do the math on that. That's in excess of $0.5 billion in working capital. That is scheduled to unwind as those airplanes get outfitted -- retrofitted, outfitted and then delivered to customers. So the lion's share of those have customers that are spoken for, and they'll be delivered in due course, but that will give us a real great opportunity to be nicely in excess of 100% conversion from a free cash to net income perspective in '21, '22, '23.

So we've got about 2 minutes. Wanted to touch on what this means for capital deployment. So last year, for the most part, you were absent from buying back stock. You have, I think, $2 billion, $2.5 billion coming due in May. You're talking about free cash flow conversion improving from here. You're still 2x levered, which I think is higher than where you normally sit post the CSRA deal. So how does that all kind of play out? When do you get back to -- I think, a lot of investors would like to see you get back to buying back stock at a nice -- at a decent level, particularly with where the stock sits today. So how are you balancing kind of the balance sheet and getting back to buying back stock?

That's an understandable question. I think when you look at the incremental debt that we took out at the time of the CSRA acquisition, we were essentially 0 net debt. We increased debt by about $9 billion. And as you well know, one of our objectives is to target a mid-A credit rating. And we were able to maintain that mid-A credit rating, even with that significant increase in the debt. Part of that was our commitment and the structure we made in that debt to pay some of that debt down fairly quickly. Part of that was the -- was about $2 billion in commercial paper, which we paid off last year per our commitment. And the next piece of that was the $2.5 billion that's coming due this year. Once we do that and meet that commitment, we'll have about half the CSRA debt behind us. And I think we'll be in a position to really look at an open landscape and say, "All right. We've got the balance sheet where we need it to be." To the discussion we had earlier around cash flow, a lot greater clarity and visibility around the cash flows. And I think we'll be able to afford ourselves a lot more optionality on a capital deployment front than we're able to enjoy last year. And frankly, I think you could expect to see us behave accordingly.

Okay. Could we queue up? Can we queue up the audience response questions here, run through these quickly? You're currently on General Dynamics.

A lot of opportunity.

Yes, I think that means higher than last year. Okay. Next one, please. General bias towards the stock right now. Okay, fairly balanced. Next one, through a cycle of EPS growth. Okay.

We have some work to do there.

Yes. Next question.

I think we can handle it.

Excess cash.

Do you want to place bets on this one?

I know that this one is going to shift. There you go.

I'm expecting that to your question.

Next question, please. What multiple of 2020 earnings? I think right now you guys are, what, 13?

Yes. Can I answer this one?

Sure.

I think that makes sense.

Okay. Next question. I think this is the last one. Most significant headwind facing the stock.

Interesting.

Yes.

I would have thought maybe more on the #1.

Yes. All right. We're out of time. Jason, thanks very much. So see you again here next year. Thanks.

Absolutely. Thank you. Appreciate it. Thank you.