General Dynamics Corporation (GD) Earnings Call Transcript & Summary

As a reminder, you have a QR code at your table. Please scan it and put answers. We would appreciate that to the questions, Jason, would appreciate it. I've seen the feedback and same to you listening online. So with that, we'll get it kicked off. Jason, we'll start at a high level. Budgets where we are in the fiscal '22 process. We've got an authorization bill signed that looked pretty good for the industry. I think looked pretty good for you all. Obviously, that hasn't yet translated into appropriations but seems to be making progress. And then maybe your initial thoughts on there's things that are now starting to come out with regard to what '23 could look like.

Yes. Thank you, David. It's great to be here. And before I start, I think I'd get a lot of grief from Howard, if I didn't mention that we'll probably address a number of forward-looking statements today that obviously brings some risks and uncertainties. And of course, you can read more about those risks and uncertainties in our 10-K, 10-Q and 8-K filings. So with that said, as you noted, I think things are trending in an encouraging way on the budget front versus how we sort of saw things maybe 6, 9, 12 months ago. If you start with the continuing resolution, I think the first positive point we saw from our perspective was getting the anomaly on the Columbia-class program. That was of critical importance, not just for us, but I think from the customer's perspective as it relates to schedule. So that was a good sign. As we look at FY '22, I think from our perspective, across the board, our programs are very well supported. I'm sure you hear that from a lot of people. But as I tick down through the major programs, I think it is well supported. You look at the shipbuilding side, obviously, along with Columbia, the Virginia Class, the submarine programs are a top priority for the Navy and for the Department of Defense in general. We got the additional DDG put back in the budget. And I think there's some good opportunity around oilers, ESB and so on. So on the Navy side, I think we're in very good stead. You look at the ground vehicle side, the Army side. We're still looking at tanks at a brigade per year, Stryker's at half a brigade per year, continuing and I think perhaps even growing support for the mobile SHORAD program, a variant from the Stryker. So really across the board, it feels like a good underpinning of support and consistent with the outlook that we've had for the business. So I wouldn't say necessarily any major upside but certainly no downside surprises there. We think we feel supportive. You mentioned 2023. Obviously, some good signals, I think, some initial signals coming out, perhaps at least hopefully getting to a place where we can cover inflation, if maybe not, get out some real growth beyond that. A little early. We'll see where that ultimately plays out. I think if anything there's a little more definitive in that outlook from our perspective. I think there's growing support for another multiyear on the DDG program FY '23 multiyear. So that would be encouraging, I think, not only from the customer standpoint as it relates to the cost implications, but certainly, the industrial base from a predictability and planning standpoint. So generally speaking, the signals tend to be trending in a positive direction but a lot still yet to be done. So I'll try not to get out beyond that any more than what I've said.

So I want to go around the horn starting with your businesses starting with the defense side of the house. So let's start with Combat. You've had a tremendous amount of growth at Combat over the last several years. You had tremendous backlog growth. That backlog has now started to come down a bit but still very large. You recently got some -- looks like some positive news out of Poland. So maybe talk about the domestic versus international outlook for Combat. I think you guided relatively flat to maybe down a little bit this year, but maybe this year and the look beyond this year for Combat?

Yes. So we've developed a pretty balanced portfolio over the years in Combat Systems between the U.S. Army side and the international portfolio. In recent years, a little bit more weighted towards the U.S. Army side, but that's starting to shift a little bit. We talked about the budget a minute ago. There's obviously been some pressure on the Army side. They tend to be a little more cyclical for us in terms of sometimes being a bill payer, and so we've seen some pressure on the Army budget. And hence, we've shifted a little bit from flattish to modestly down for the coming year. I think on the other side of that is the significant international opportunity set that we see. The issue with international work, obviously, is the timing and the predictability of that and when that comes in is a little less certain. So I think there's a broad opportunity set. We think about the risk and the threat and the perceived threat around the world. It's clearly quite obvious based on the last 24 hours and the last couple of weeks of activity that the world has never been a more dangerous place. And so we see those demand signals throughout the world and particularly in Europe these days. You mentioned Poland. Obviously, there's been some momentum picking up on that opportunity for the M1 tank sale into Poland. It is still an FMS program. So that's something that from a timing perspective, we'll need to wait and see. We can't predict that with any certainty, but I think there's -- the customer has got some optionality for how quickly or how long that will take. So we'll obviously be supportive of that along the way. But there are other opportunities throughout Europe as well, and we're chasing that both through our Land Systems business as well as our European Land Systems business. So again, timing less certain. I think we're still predicting a bit of a volume dip this year. And if you look further out into our plan period, we think enough of those opportunities will manifest both on the international side as well as in the U.S., you think about the MPF program for the Army. We think we're in a good place on that front. So that gives us a good, reasonable expectation to start seeing a return to growth in the out years of our plan.

Okay. Moving over to GDIT. Talk about the growth outlook there. You went through a couple of years where I think the growth profile kind of disappointed a bit but seems to turn the corner. How you've been doing in terms of the bid pipeline in terms of recompetes and competitive bids, what you're -- how you've been going from a win rate perspective.

Yes. I think GDIT did a really remarkable job last year to get the growth that they did in a very tough environment when you think about the procurement environment and some of the headwinds that they've faced. They had a little over 2% growth last year. You look at the Technologies group as a whole this year, we've forecasted, call it, 3% to 3.5% growth. One of the things we've talked about in that portfolio is Mission Systems and some of the issues they're dealing with from a supply chain standpoint and how that's kind of creating a headwind to their volume outlook. So notionally think of them as modestly below that 3% to 3.5% growth rate. And then on the other side, we think GDIT is more in the mid-single-digit range, so accelerating from last year. And again, that's all the good work they've been doing in terms of their win rates in this very tough environment in terms of the procurement protest environment and the things we're seeing there. So you talk about win rates, they have consistently booked a 70-plus percent win rate overall, and within that 90-plus percent win rate in terms of recompetes. And so that has been a steady drumbeat for them, just performing on that opportunity set. The head scratcher for us, and I've alluded to it a couple of times, is this procurement environment where we are seeing more and more, it's not abating, it's, if anything, getting worse, these bottlenecks around both the time that it takes to adjudicate an award once the bids are in, and subsequently the level of protest activity and the delays that, that creates in terms of being able to get that work started and get the product delivered to the customer. So I think we mentioned last month, when we look at awards that GDIT has actually received, but it's under protest, and we can't start that work. If you go back to the end of 2020, that was roughly, I think, $800 million of total value that was hung up in that stage, and that grew to something in excess of $6 billion by the end of last year. So that's just a staggering figure. When you think about the frustration, it's got to be on the customer, from the customer's perspective, but certainly ours as well. We are poised and ready to do that work, and the procurement environment has just been a bit frustrating. You go further up the funnel and you look at the amount of awards that have been -- or the bids that have been submitted and are awaiting adjudication by the customer, that's grown in that same time frame from roughly $16 billion to $32 billion. So that's -- not all that comes to us but we've been, as I said, winning our fair share year in, year out. Those are significant bottlenecks that are inhibiting the potential growth, I think, of this business. We're still eking out this growth, and I like the trajectory we're on, call it, 2%, 2.5% to mid-single digit, and we'll see where it goes from there. But we've got to see some of this free up and see that value flow through so we can get it to the top line and ultimately get the products and services delivered to the customer.

The margin profile at GDIT, I mean we can't see it exactly now as it's part bundled with Mission Systems as part of Technologies. But it would appear that you have industry-leading margins in GDIT. Can you talk about how that's the case? I mean is it the work they do and how you bid? Or just how -- it looks like your EBITDA margins are in the 12%, 13% range for that business.

Yes, it's funny you asked that. It doesn't escape you that when we did the CSRA acquisition, which was almost 4 years ago, one of the questions we got sort of from a skeptical lens was how are you going to possibly maintain these EBITDA margins that they've been carrying? And what's interesting, as I've looked at it, that business, when we combined the 2, we did take the initial benefit of CSRA in the mix, but that business's EBITDA margins have grown every year since then. And they hit a new high in the fourth quarter of 2021 and a new high for the year of 2021 as a whole. And so that's to their tremendous credit of, frankly, what we across General Dynamics focus on. It sounds mundane and it sounds a little boring, but the fact is it's operational excellence, it's performance, performance, performance on those programs. And we're continuing to see that. And I don't see it slowing down for those guys. I can't say enough how impressive it is that they took on that step function and continued to grow it over time. Obviously, there was the synergies of the integration of bringing those 2 businesses together but that's behind us. And now it's just continuing to take that discipline into the operation to grow that margin. So really impressive.

Moving over to Marine. So you guided to low single-digit growth in Marine this year. I think you did that at the beginning of 2021. It came in, well, a fair amount of above...

You're going to call me a sandbag. No, just kidding.

So I guess what drove the upside last year. I thought there would be upside, there was upside. I guess what drove the upside. Why don't we see upside this year? I think you've talked about kind of this incremental $500 million a year in revenue as Columbia ramps up. Why don't we see that this year potentially?

Yes, you've made the point, and I'll sort of expand on it. We have talked about this business growing between $400 million and $500 million a year, fairly predictably over time. So let's look at what's happened. When you take the combination of 2021, last year, and we had a little bit of an overshoot from the target. We did better than we thought, and that's largely on just workload and material timing, frankly, more than anything else on these large programs. That has a little bit of a drag-on effect into this year, which is why this year is predicted to be down a little bit. But if you look at the 2 in totality, I think the average is about $425 million in growth between those 2 years. If you take a broader look and go back over the last 10 years, we've averaged just under $450 million a year in growth over that 10-year period in this business. And when you look out over the next 4-, 5-year planning horizon for that business, the average growth is just over $450 million a year. So when you think about -- that's a 15-year window, when it goes beyond that, I don't know that I could ask for a more predictable, steady drumbeat of growth. Any given year, you might get a little better, you might be a little down. But on average over that period of time, I think it's been very compelling, and it continues to be compelling growth as we look out into the future. The key, from my perspective, is that we continue to eke out margin improvement over that time, right? So we talked this year about gaining about 30 basis points, give or take, from '21 to '22. And I think we've got to see that drumbeat continue. The growth isn't enough. We've got to see the margin performance in that business. And I'm not talking about 50 to 100 basis point step function jumps year-over-year. These are long, durable programs and it takes time to work through the learning curves on those. But 10, 20, 30 basis points a year, we ought to see that expand over time as we get back to that between 9% and 10% margin rate range for that group. I think there can be perturbations from quarter to quarter and year to year. But in general, that's what we would like to see.

Can you expand a little bit on that in terms of the margin opportunity? I mean is it Columbia in terms of as we go through the transition there, is still more opportunity out in Virginia class? How do you kind of bucket that margin opportunity?

Yes. I think when you look at last year, it was really almost a serendipitous confluence of low points in each of the programs. And what do I mean by that? You have Columbia coming into the first build contract on a cost-plus basis at very conservative, entry-level margins. You had the start of a multiyear on the DDG program. You've got entering into and ramping up on Block V at Virginia-class. You've got the start of the T-AO Oiler Program. Each of those is in an early stage at the same time, starting out at what would be typically early rate margins for those types of programs. So over time, we'd expect to see those rise as we go through the process, get down the learning curves and start to realize some of the benefits from that process. When you look beyond that, you talk about Columbia, you get out to FY '26. So end of calendar year '25, you get the second construction award that will be the third boat in the program, which will be a fixed-price contract and you start to get the ability to bring in fixed-price type work. So not just over the next 1, 2, 3 years, but out over the long run, I think there are underpinnings of margin growth in this business. We just got to go do it. You need to say it, like we just did, but they got to go do it. But that's certainly our expectation if that happened.

Okay. So moving over to Aerospace. I guess to start with, can you just level set us from the standpoint? So last year, I think you under produced and over delivered. You had the inventory. This year, you're going to over produce, I guess, on G700, produce inventory. Just kind of what's going on there? What that meant for working capital? I think you liquidated inventory last year, maybe you're going to build some inventory this year. What -- kind of what -- before we talk about the longer-term at Gulfstream, what went on in '21 versus '22 in terms of deliveries versus production?

Yes. To your point, I think you said -- you called it under produced. Maybe we over delivered, but I think to your point, we had a number of elements in the portfolio that led us to deliver more units than we produced last year, right? So we delivered out the test articles that have been in inventory on the 500 and 600 programs. We delivered out the final G550s, which are no longer in production. And so we ended up, to your point, having more in the 119-or-so deliveries that we had relative to what that would mean in terms of the production activity in the facilities at Gulfstream. You've -- I'll pause there and talk about working capital for a second. If you think about what that did, that was a tremendous amount of OWC liquidation, right, bringing all that inventory down. We also had tremendous order activity last year, which helped from a deposit standpoint. So Gulfstream was a significant contributor in cash last year and really got their balance sheet in a much better position after having come through the -- some of the product transition they've been doing. If you turn that over to this year, and to your point, we're now in a build ramp on 700, which, of course, is towards the end of this year that you get certification and entry into service but then the more significant ramp in deliveries for that airplane is in 2022 and beyond. So we are building some inventory there on that airplane. But when you look at what that means in terms of, let's talk first about deliveries versus production. We're now producing more airplanes than we're going to deliver because of that 700. But let's look at it apples-to-apples for a minute. If you think about the apples-to-apples in production airplanes, the 280, the 500 to 600 to 650, we are actually ratcheting up production on those airplanes by about, call it, 15% year-over-year. But when you normalize for the anomalies of, again, the test airplanes, the 550 going out of service and the 700 ramping, that's what's actually fundamentally happening under the surface in the in-production airplanes for the business. That's as we ramp toward the growth we projected for 2023 and beyond. Turn it back to the working capital for a minute, we will see some inventory growth as a result of the production build on the 700, but you'll get the knock-on effect of the ongoing progress payments from the order activity we saw last year. So we ought to see those advances in those progress payments helping to offset that. So net-net, we don't see Gulfstream being a large builder or a liquidator of OWC this year. We think on balance, they're in a pretty good place, and they've got some opportunity to further bring that OWC down in the out years, but this year should be pretty stable. That's a long answer to a...

Yes. And it sounds like you have a bit of a -- you might actually be able to -- you might have the demand to build more airplanes this year, but you have the bottleneck in terms of wing capacity. Maybe talk about why that bottleneck kind of exists? The fact that you brought in-house all your wing production over the years and why you kind of are in that position today where it's going to take a little bit of time to add that extra wing capacity.

Yes. This is a real success story for Gulfstream and something that is, from my perspective, very impressive. When you think about what they did over the years, when we've gone to this multiyear, multiproduct expansion and investment in these new platforms, likewise, they've had to invest in the manufacturing capacity to handle that broader portfolio of airplanes. And they've been doing that over the past decade. In the midst of that process, think about what happened. We had a major supply chain failure that caused us, to your point, to have to integrate wing manufacturing that was not anticipated. So they did that. And frankly, they did it in a way that I think from a quality and cost perspective makes them arguably the premier wing manufacturer in the world, and it's incredible what those guys in the operations side of Gulfstream were able to do, frankly. But again, that was not originally anticipated. They did it, they integrated it and they did that without missing a beat on this -- in terms of the profitability and the production cadence for that business. What happens then? COVID hits and we tightened up on that business, ratchet down production and put that -- and rightsize that, if you will. And then just as quickly, the demand whipsaws back to where it was and overshoots to a higher level. So now we're looking at that and saying, "Well, we got to go catch back up and meet that demand". So this, once we integrated the wing capacity, there was always an intention to get that capacity up to where it supported the longer-term growth. They were doing that successfully but the whipsaw of COVID sort of put a little monkey wrench in that. And now we're having to go finish that process, get the expansion of the building in place, get the tools and fixtures in place and be able to support that increased production. That's -- now the hard work, I think, is done. They just got to get that in place and get that expanded capacity there. And that supports, along with the facility build-out that I referenced before, that fully supports the growth of the 148, the 170 and frankly, gives us capacity beyond that for Gulfstream. So once we get that tooling line in place and that building expansion, which will be done in time for next year, we're good for the long run, I think, from a production standpoint for Gulfstream.

So on the last call, you laid out the forecast for Gulfstream for the next couple of years. Certainly in the out year '23, '24, I think a lot higher than what most of us were expecting for both '23, '24. So I guess what gave you the confidence to give that longer-term outlook? And how does the transition from 650, 700, 800 kind of play into all that, the kind of incremental, kind of demand that you're seeing for -- particularly for the 700, I would say?

Sure. I think when we, obviously, we stepped outside our normal cadence to give that multiyear outlook and people asked, what made you do that and how to do that. I think first and foremost, there was a compelling reason to do it. And that was sticking to the 1-year forecast for that business. I don't think adequately or accurately would have told the story for what's happening for Gulfstream, in terms of the recovery and the emergence from COVID. You needed to see that -- if you had just looked at the snapshot of '22, I think it would have been a real head scratcher in terms of what's going on and what does this mean? What are the implications for the long run? So that was the compelling reason to do it. It doesn't mean you'd necessarily be able to do it. There had to be another factor there and you alluded to it, and that's the incredible demand that we've seen over the past, call it, 1 year plus now. Really it kind of emerged about this time last year. It really heated up and hasn't stopped since then. And so that gave us the ability to give that multiyear outlook. And so what we're seeing, frankly, is demand across the board, not only for the new products. And there is healthy reception. There's a great reception, strongly received 700, 800, 400 introductions, and we've seen good order activity on those. But I think as importantly, if not more so, all of the existing in-production airplanes, we saw a significantly higher number of orders last year than we had deliveries for every aircraft, including the 650 by the way, which -- let's be clear, the 800 is intended to replace the 650, but we're not going to declare the 650 dead yet. It's got a lot of life left in it and a lot of demand right now, and it continues to have tremendous order interest. So this is -- I don't want to call it unprecedented I don't know that I've been around long enough to call it unprecedented. But it's really staggering, I think, the level of consistent order interest that we've seen at Gulfstream, and it's continuing today, even as we're going to start to make our way through this year. So what does that mean in terms of this growth trajectory? You talk about the 700. Obviously that, I mentioned earlier, that the significant ramp we see for that airplane starting in '23, that is the driver behind -- that's the big driver behind the big step-up in revenue that we talked about for next year. And then following on from that, the 800 is, call it, 6-ish months or so, give or take, following the 700. That obviously is driving the next step function up in volume in 2024. We've talked about how each of those airplanes will enter with accretive margins to the group as opposed to some of the other airplanes that we've had, the 500 and the 600 You know that story we've talked about it for some time. Those will enter with accretive margins and grow from there. So that's part of that margin uplift story that we've talked about as well and the expansion we expect to see in '22 and '24. So overall, I mean, I think the trajectory is great. It's incredibly encouraging, and the momentum continues today.

So now I have to give you a hard time on the margin.

Can I leave the witness there, or maybe the other way around.

So you're implying like low 20% incremental margin over that forecast period which, okay. But just the -- given the pricing dynamic, you just talked about the accretive margins. What else is going on within that in terms of maybe R&D? Or anything else that would kind of dampen the outlook that we wouldn't potentially see better than low 20% incremental margin? I think you've done better than that in the past.

I gave an apology for the 20% incremental. But look, I think, obviously, it's a complex business with a lot of moving parts. Let me kind of keep it to 4 major movers and I'll try and keep it brief. On the first hand, most importantly is the underlying fundamental operating performance of each production line and we are continuing to see that. If you don't have that, the rest of it is ebbs and flows and bubbles and things like that. But if you have that, then it's sustainable. And so we continue to see the 500 and 600 come down learning curves and improve their profitability in terms of their manufacturing efficiency. That is first and foremost for us. I already alluded to the entry level and growing margins on the 700 and 800. So when you think of the productivity of the manufacturing operation there, that is sound and that's highly supportive of that incremental margin you talked about. The second piece would be really sort of, I think, pricing, if you will. You alluded to that. We see a lot of signals in the market right now. There's a lot of discussion around the preowned market and what's happening there in terms of lack of availability, what that means for pricing. That tends to be supportive of new aircraft pricing, and we are seeing that across the board, upward pricing pressure on all models. So 2 major elements that are highly supportive of this margin expansion. Flipping the other way, the service business, great story here. We've now recovered back to pre-pandemic levels on the service business. We're now at a point where we're growing beyond what we saw in 2019. That's certainly an encouraging narrative for the overall state of the business and the state of the market. But of course, that comes at incremental margins that are dilutive relative to new aircraft manufacturing margin. So as that grows, great business, but it's going to have a dilutive effect on the margin. And the more significant piece that's the offset, and you mentioned it, is the R&D effort. So obviously, we have a long-term ongoing commitment to the R&D in this business. but there are going to be surges and peaks and valleys, right? And right now, we're clearly pushing forward with the flight test on the 700, heavy-end of that certification effort. The 800 comes on the heels and then, of course, we've got the 400 right behind that. And so we're going to see elevated R&D. We've talked about that for this year and next, and that it notches down a little bit the year after that. So that is the biggest weighing factor on the margin profile versus the productivity and the pricing environment. I will say to remind everybody that we had talked years ago about getting this business to roughly $10 billion revenue base sort of mid- to high teens margin rate. And now we're talking about a roughly $11 billion business with a mid- to high-teens margin rate. So I feel very encouraged that subject to a 2-year interregnum, if you will, from COVID, this business is right on track and doing everything that we expected it to do. So extremely encouraging outlook.

So with the last couple of minutes we have left bringing this all together, I guess, to talk about the cash outlook. You went through this bit of a valley where you had free cash flow conversion below 100%. Last year, I think you were slightly over. You're talking about well over 100% depending on what happens with R&D amortization. Just, I guess, walk through the moving pieces that keep you at 100% plus in the future? Maybe if you could talk about contract assets and some of the -- what's going on there in terms of Canada and maybe AJAX? The CapEx profile? Yes, go from there.

Yes. I mean the major building blocks, if you take it business by business, I won't spend a lot of time on Gulfstream because we have talked about that. So again, strong contributor, not necessarily a major builder or liquidator of OWC. And when you think about each of these businesses, we expect each to be a roughly 100% cash converter year in, year out, subject to perturbations either in OWC or capital expenditure investments. And so that's Gulfstream. You mentioned a couple of the elements of Combat Systems. We continue to bring down the OWC on the large Canadian international program. That program was sort of reset, if you will, a couple of years ago and we've continued to receive consistent timely payments on that, and we continue to liquidate that OWC, and we'll do so through the balance of this year and next year until we get to sort of a steady state there. So that's a tailwind, if you will, from a cash perspective. On the AJAX side, the customer is very focused on a couple of technical issues we're dealing with that development program. There are issues that are in no way atypical of that kind of development program, but they're prioritizing them, and so we have prioritized them as well, and we're supporting that effort. I think once we come through that path, and we're on a path toward that, we'll start to see that OWC unwind when we get past that point on that program. So in the moment, Combat Systems is a tailwind to the cash story. Marine Systems. That profile is dominated today about by the capital investments that we're making. We didn't experience as much of a steep peak and as much of a steep decline. We kind of hit -- we rose, plateaued, and we've been at an elevated state for a little longer. Some of that has to do with COVID and what you'd expect in terms of our prudent managing of that CapEx to both meet our commitments but also prudently manage the cash. So that will remain at an elevated state this year, start to notch down a little bit next year and then get -- sort of essentially return to normal after that. So that is really the biggest headwind, I think, that keeps us from being significantly over 100% right now. But when you take those on balance, plus the fact that the Technologies business just year in, year out prints in excess of 100% of net income, that gives us that comfort that we are comfortably back in a place where we're at and above the 100% conversion rate. And you alluded to the R&D. If we can see that deferred that R&D capitalization from a tax perspective, we can see that deferred, that puts us comfortably up in the 110-plus percent. So I think it's a great cash profile on our growing business, and I'm really encouraged by the opportunity set.

All right. Great. Do we have any audience responses. We do. Great. All right. One. All right, we can quickly run through these here. Okay. Great. All right. Well, we're out of time today. Jason. I appreciate it.

Absolutely. Thank you very much for having me.

Thank you.