General Dynamics Corporation (GD) Earnings Call Transcript & Summary

Good morning, everyone. Welcome back to the aerospace, defense track at the 2022 JPMorgan Industrials Conference. I'm Seth Seifman, the U.S. aerospace, defense equity analyst, and we are very grateful to have some time with General Dynamics this morning. We have Phebe Novakovic, CEO; Jason Aiken, CFO; and Howard Rubel from Investor Relations. Thank you all for being here. We really appreciate it, and yes, welcome.

Well, thank you for inviting us. Hey, before we get started, Howard Rubel says I have to say the following thing. Any forward-looking statements made today represent our estimates regarding the company's outlook. It's considerably shorter than what's in all the public documentation, but that's as far as I'm going.

Excellent. Very good. And so maybe we'll just do some Q&A this morning.

It's fine by me.

Excellent. And so we've got some folks here in the room as well. I'll start off. I'll ask some questions. We'll maybe look out and see if anyone has any questions in the room. But maybe I'll kick it off. And I guess, as we kind of start off in the segments and rotate through some of them, we can start off in Aerospace. And I guess even before getting into any specific questions, could you talk about the overall demand environment at Gulfstream?

So we've witnessed a strong year of spectacular growth. And in order to satisfy that growth and our customer needs, we need to increase production. As we talked about in the fourth quarter call, that entails expanding our wing building just a bit and some new jigs and fixtures, all of which will be in place in 2013 (sic), as we talked about on the fourth quarter call -- or 2023. And look, I think that there are a number of factors driving the spectacular growth. I think, certainly, our new family of technologically advanced airplanes is a big and substantial driver. Second, we've seen an increase in global wealth. The dissatisfaction with business travelers with some of the airlines is yet another factor. And the Fortune 500 are replenishing their fleet, and that is yet another factor.

Well, that kind of leads into one of the next questions that I had. And if you think about those being sort of sufficient drivers to sustain the level of production increases that we're going to see across the larger jets, we know about the production increases planned at Gulfstream. Bombardier has talked about plans to increase production, Dassault is going to be bringing a jet to market, I think, in 2023 and then again in 2025. At the same time, we have sort of these structural supports. And so whether your production outlook sort of dovetails with your outlook for what the entire large jet market can do.

So we gave you a sense in our fourth quarter call and projections of the year of '23 and '24. And for '23, we told you we're going to produce about 148 new airplanes and take it up to 170 in '24. So the demand supports that production level. And our facilities, manufacturing efficiency, are all in line to execute quite nicely on that increased production.

And then so another part of the outlook for Gulfstream was increased profitability. And so we saw margin last year, a little under 13%, the goal of taking that solidly into the mid-teens over the next few years. Can you walk us through the key drivers of that expanded profitability?

So clearly, increased volume is one, increasing airplane manufacturing efficiency and price are all working in the right direction. There are 2 factors that are somewhat offsetting that a bit. One is the R&D spend and second is the increase in service volume. Service volume is back to pre-pandemic levels, but carries with it different operating margins. So I think that gives you a sense of the puts and takes on what is a very complicated business.

Right, of course. I guess one question that comes out of the terrible events that we've seen in Ukraine is the question about exposure of Gulfstream and Jet Aviation to Russia as a source of revenue.

So Jet Aviation's MRO business is likely to be impacted as a result of the sanctions, primarily in Geneva, somewhat in Basel and in Austria. We expect some impact on their managed airplane business. But for Gulfstream, Russians constituted about 5% of their total backlog, and that's well manageable within the current demand environment.

Okay. When we think about the production ramp at Gulfstream, what are some of the challenges as you think about raising production in the type of environment we're in now with regard to sourcing materials and with regard to labor?

So we have a very robust supply chain management operation at Gulfstream. And we work very closely with our supply chain before we project production levels so that we can ensure that they can be met. Gulfstream has a long history of successfully helping out it's -- and stepping into its supply chain when needed. And I think at the moment, what we're seeing -- and we think that's all manageable. At the moment, what we are seeing is a shortage of skilled labor and increased cost of skilled labor, but we're managing through that challenge. Outside of Gulfstream, I would say that Mission Systems and our defense side is the most impacted by supply chain perturbations, which we talked about on the third -- and I think third and fourth quarter calls of last year, primarily in chips. But they worked well through that last year and will continue to work on that this year.

Okay. On the -- I know there's a couple of new platforms coming to market at Gulfstream in the coming years, particularly the G700, where flight test program continues on G800. What's the latest on G700, the engine certification?

So the engine certification is on track. There are no major surprises. The engine is performing extremely well and, frankly, in excess of its specifications. The fourth quarter of this year remains our target. The pacing item here, however, is the availability of the FAA to review all of the data that we are producing, and we don't control that.

Right. That was, I guess, a follow-up question I have, covering Boeing as well. We see that it seems like there is increased scrutiny from the FAA on everything these days. And so I guess, is it your sense that the -- that maybe things are under a little more scrutiny than you might have thought a year or 18 months ago, when you think about that target for entering service in Q4?

Well, we had anticipated -- after the Boeing issues and problems, we had anticipated additional scrutiny and had factored a good chunk of that in. But as I say, their availability and resource availability to review all of this is the pacing item. And we had estimated that we could accommodate much of that, but it remains without -- outside of our control. As I say though, the fourth quarter of this year remains our target. If that changes, we'll let you know. It won't change by a whole lot if it does.

Right. And is it a similar outlook for the 800 in terms of schedule and testing similar, going according to plan and FAA availability being the pacing factor?

I think significantly less, given where the 800 is in its developmental cycle. And we still are anticipating about a year after the certification of the 700, that we'll get full certification of the 800. But there is significantly less testing involved.

Before we move on from Aerospace and Gulfstream, just look out at the room, see if there are any questions on that topic.

No Gulfstream questions. Whoa. [ It's a seminal day ].

Yes. Maybe we'll just throw in -- just throw in one last one here. I don't know if this is something you can do at this time. But just, is there any kind of magnitude for us to think about in terms of that impact on Jet Aviation that you referenced?

We're currently assessing that. And as you can imagine, the multitude and complexity of all the sanctions, we are systematically working through all of those. So we don't have a really good point estimate at the moment. I suspect by the end of this quarter, we'll have a better sense and will update you on that. But it would be folly to think that Jet, in particular, given where they're located, won't see some impact.

Understood. I guess moving on to Combat Systems. There's a piece of Combat Systems, I'm most everyone of you know, that's based in Europe, where they build combat vehicles particularly for European customers. And one of the main outcomes of the Russian invasion in Ukraine has been European pledge to increase their defense spending. I guess, how do you think about how the environment for European land systems might change in the coming years?

So for those of you who have been with us for a while, you know that we have long talked about, defense spending is driven by the threat or the perception of threat. While there is a clear and present threat and manifestation of that threat in Eastern Europe, as a result, we've seen a number of our allies indicating that they would increase, as you quite rightly know, defense spending. And ELS' products or given their location, particularly in demand at the moment. But look, I think it is both premature and, frankly, inappropriate to fully speculate on how all of this really painful and dangerous situation in the Ukraine plays out on demand. We'll see when we get it.

Okay. Yes, I think -- understood. And if we -- I guess, if we put that aside, maybe for Combat, and we just think more broadly about the different pieces of the business. You've got 2 major domestic programs there in Stryker and Abrams. And so I've got a couple of questions about other pieces, but maybe we start with those 2, and the outlook for each of those pieces within Combat over the next few years.

So if you all follow defense appropriations, you'll know that the Abrams was funded in brigade a year, and Stryker above the half a brigade a year that we had anticipated. The Army has increased its demand signal for the mobile SHORAD air defense system that is on the Stryker. So I think all of our key franchise programs, vehicle programs are very well supported.

And then when we think about the other sort of few international programs that are outside of European Land Systems. And so I'd say that there are some that are probably maturing and maybe plateauing or will come down in the coming years, the Canadian contract, the U.K., AJAX; and then those that are ramping, tanks in Poland, the Dragon program in Spain. If we think about those international programs on a net basis, what would be the outlook there as we look out, let's say, '23, '24?

So let's talk about them seriatim. AJAX has yet to ramp up. And once it does, it will have a multiyear production run well outside our plan window. The large international contract out of Canada has another 3-plus years of full production. The Canadian LAV program is frankly just getting started, and it's got another 4 years of production. And the Spanish 8x8 of -- or the Spanish vehicle is, frankly, just beginning its production. And it's got a pretty long tail again, outside our planned portfolio. And of course, we've got demand signals for the Abrams main battle tank, largely through FMS, [ whole industrial ]. So we'll see what the timing of that, given the FMS processes.

Okay. And you mentioned AJAX still kind of heading towards the ramp-up. Is that in a place now where things have been defined kind of as you and the customer would like to see them defined? And it's kind of known how the production phase is going to proceed?

So we understand this vehicle. We know what its exquisite capabilities are. The U.K. government has repeated its need for this highly advanced combat vehicle for the U.K. Military. But we're still working through with our U.K. customer the exact pacing and sequencing of the production cycle going forward.

And so as we roll all of that up, I think the kind of 2-second conventional wisdom that people had about Combat Systems is, there's a strategy that the U.S. has that's more of a shift towards Asia and the Army is not at the center of that strategy. And therefore, it's going to be difficult for Combat to grow. When we talk about sort of the different pieces you've laid out for those international programs, for Abrams and Stryker, I think it seems that Combat is not -- may be not the fastest-growing piece of the portfolio. But how would you characterize the 3- to 4-year outlook for the business?

So the world has dramatically changed, I think, since that narrative was the point of the realm. And we continue to see Combat, at least at the moment, as a pretty steady low single-digit growth vehicle. But look, that could change given the environment. But as I said before, we'll just have to see how all that plays out. It is a dangerous world. This is a land war in the Ukraine. And our land forces are -- in fact, all land forces of our allies are in fact the issue here. So we'll just need to see.

Absolutely. Okay. Let's talk a little bit about marine, and the dominant program there being the Columbia sub. If we think about the next, let's say, 12 to 24 months, what are the key milestones that you're looking to reach on, on Columbia?

So the growth of Columbia construction continues at a very nice pace. We are almost 20% complete with the construction on the first boat. Submarine production is long and doesn't necessarily have discernible, tangible milestones that you can take a look at. But I think the first one that you might be able to get your heads around is the joining of the first 2 modules, fully completed outfitted modules, which is scheduled for 2024. And I will note that we are ahead of our accelerated internal schedule in Columbia. So, so far, we're very pleased with where this program is.

Okay. And then on Virginia, over the years, I think there's been kind of on and off talk about whether to increase the production pace or not. When you think about what's required to do that to make it worthwhile for Electric Boat and for Newport News to make the investments to have the visibility there, whether there will be a sufficient reliable commitment from the Navy to kind of stand behind that effort to make those investments worthwhile. Is that something that you think is a possibility over the next few years? Or is it something that would just put too much schedule and execution risk on the system, given that building 2 Virginia boats a year and the Columbia work that Electric Boat and Newport News are doing is more than adequate for the next several years?

So we have been working for some time with our Navy customer on the most cost-efficient way to increase production to 3 a year. Clearly, some investment would be required. But I think, first, we need to get the supply chain cadence in place to support the current 2 a year, give them time to recover from the ravages of COVID. So we'll see. We're not planning on a third Virginia at the moment, but -- we're not anticipating it, but we certainly are working with the Navy for pretty detailed plans around that, should that -- should they choose to ultimately increase that production.

Okay. And then one of the things that I was interested to see this past year in the 10-K was that the biggest contributor, I think, to growth in Marine was the surface ships. And if you could talk a little bit about the progress that the company has made at Bath and what a path to profitability at Bath might be on the destroyers.

So as we talked about Electric Boat in the past, and it remains true today, that their growth trajectory is clear, discernible, and in our mind, inalterable. But it will have periods of a little bit of variability. Last year was one of those periods, where we saw a little less on -- out of Electric Boat. So the increased demand signals from the Army -- or from the Navy on surface combatants, the DDG-51, were clearly there. In fact, there are indications that they want even more 51s. And NASSCO's performance on the oiler will continue to drive growth. But let's get the predicate right with respect to Bath. Bath is and has been profitable. We're working very closely with our union partners to increase productivity, and we're doing quite well with their support in the realization of that objective. So the clear driver over the long run for our Marine Systems is submarines with nice support from the surface side.

Okay. Very good. Moving on to the Technologies business. You have both products and services as -- across the company. And so how do you think differently about those 2 markets and about the demand signals that you see from those 2 markets? And that's not necessarily just the products and services within Technologies, but across GD.

So I think products and services have different market dynamics and different market demand. That said, we have argued and in fact, witnessed an increase in service demand driven in part by the criticality, the importance of IT to the war fight. And we expect that to continue. But in my mind, make no mistake, it's our product growth that will really drive the company's defense business growth, and that's manifest primarily in Electric Boat. And we don't expect that to change, as we just talked about a few minutes ago. But those are the real big drivers. We'll see some nice growth on the service side, but the real driver will be in our products side of the house. And I will tell you, it is entirely possible that, in this spread environment, that we see increased weapon system demand, frankly, across the sector.

We saw the end of the continuing resolution, I guess, just this past week. The President signed the appropriations bill. Does that kind of break a logjam at all within the services business and allow for some acceleration in growth there?

Interestingly enough, this particular CR -- and by the way, CRs are not the way to run a railroad. But that said, for us, this particular CR did not have much of an impact. So what we anticipate with respect to the considerable sort of constipated backlog in service awards is that they will systematically and methodically work through those over time. And then, of course, as we've talked about before, the big variable seems to be the ubiquitousness of protests. So we'll see the timing of all of that, but the demand is there.

Okay. And then what are the drivers that we should think about for the Mission Systems piece of Technologies, and kind of how this plays into the overall growth within the segment?

So Mission Systems, all about a decade ago was a -- particularly at the time, our C4 business. We combined our C4 and our Intel business a few years ago. But at the time, the U.S. Army was a big driver of growth. That business will remain steady at a far lower growth rate, but we don't see it as a particular growth engine here. For Mission Systems, it's really their marine work, their Navy work and their satellite payload work, and frankly, satellite ground station work. Those will be their drivers. But again, we haven't seen Mission Systems as -- they'll see nice low single-digit growth from -- in our horizon, but the growth in that in that particular segment is driven by the IT business, service business.

Cool. Before we move on to maybe some of the more broader corporate questions, I'll just go around the room and see if there's any questions about any of the segments.

I'm glad to see we fully answered all of your questions.

Okay, well, we got them all here. Okay. So let's talk a little bit about cash. And there's a goal, I think, to kind of return to 100% cash conversion and to surpass that level. How long can the company continue to convert net income into cash at a level that's above 100%?

For the foreseeable future.

Okay. So maybe -- I mean, think about that as being in the planning horizon of 3 to 5 years or so?

That's right. Yes.

Okay. Okay. And then in terms of what to do with that cash, the company has been, I think, looked to be opportunistic in the past. Stock has done quite well recently. Do you think differently at all about share repurchase plans given how well the stock has done?

So we have a number of levers to drive value creation for our shareholders. We've just increased our dividend for the 25th consecutive year. We've got some debt to pay down by year-end. We'll continue to invest in our business where we see our ability to drive returns, and we will be timely in our acquisition of our stock.

Okay. And on the M&A front, is there anything out there? How closely do you look at it? I think one of the things in the background here is we've seen some regulatory opposition to concentration in the defense sector. But GD has traditionally been a company that's had a range of businesses, and so it maybe provides more opportunity for the company to do something that's part of the -- that expands the range of businesses that you're in. Is that something that you consider at all?

We like our portfolio. And beyond that, I'm not going to speculate about M&A. You guys are very creative in all the ways you can find to ask that, but the answer is still the same.

Okay. Very good. Okay. If you'll -- maybe you'll forgive the lack of tact here. But I wonder, succession planning is a key element of governance. And we've seen some other companies in the sector announce different things recently about COOs and things like that. I guess, what are your updated thoughts on succession planning and how GD is approaching that?

So for the entirety of my career at GD, and it's certainly been accelerated as my tenure as CEO, I have developed, worked hard to develop, a strong cadre of younger, very capable executives. And we are fortunate at GD to have exactly that. The next CEO will be an internal candidate.

Cool. And is there anything...

That wasn't that tactless, by the way.

Maybe I'll push the envelope then.

Don't.

Okay. And any thoughts about the time line for that?

We've got more work to do here. So I'm -- we'll stay the course.

Yes. Excellent. Very good, very good. I guess one question that I've had that I asked Northrop about yesterday as well was the topic of ESG. And so I think ESG can be sometimes a difficult thing for defense companies, but I think in recently -- at least in recent weeks, we've seen some of the ways in which the things that defense contractors do to contribute to social good. And so what kind of conversations do you have with investors about ESG? Maybe let's start there. And then maybe I have a couple of follow-ups as well.

Well, thinking people who understand the nature of human beings, that fundamentally, that nature never changes, understands that there is evil in this world. And the fundamental purpose of our defense industry is to deter that evil. And it exists. And if you needed any reminder of that, it's manifest itself most recently in Eastern Europe. We remind those people who raise these kinds of questions of that fundamental reality. And we are both proud, have a regulated conscience about everything that we do to support the United States and its allies. We are -- and frankly, it is a good and great thing that we've got this industrial base, and we are unapologetic in our support of the United States. So with respect to other elements of ESG, I've long believed that a successful company takes care of its many stakeholders. That's how you create enduring value and you ensure the long-term success of your company. So we have always focused on the other elements of ESG, and we'll continue to do so.

And on the Gulfstream side, I guess, how do you -- what do you point to when you get investors who ask about the, let's say, carbon implications and things like that and the things that you can do at Gulfstream that kind of can allay some of those concerns?

So one of the many meritorious outcomes of this investment in this new family of airplanes that we've developed is far more efficient, quieter engines with a far better, greener output. And I think that, that is a significant part of what we do. That, plus our -- we were early adopters of sustainable fuel and have continued to do so. I think we've surpassed the 1 million-mile flight mark of miles using sustainable fuel, and we'll continue along that path. Some of the more uninitiated in the world might believe that a defense company doesn't think about green, but we have been green before green was necessarily cool.

Have you gotten much sense yet? Or I guess, going back to the question about ESG and defense, I know it's been early days. But have you gotten much sense yet from conversations with investors that the thought process around this issue might be starting to evolve?

We haven't heard that from any investors in particular, but we'll see. I think the reality of the world today should be illuminating to those who may have had doubts.

Good. Maybe I'll go one more time. I've got a few more questions, but I'll go one more time out to the room, see if there's any questions out there. Cool. Maybe we'll move to a lighter topic, I mean would talk a little bit about Gulfstream demand and just the various pieces of it. Kind of what have you seen that's different since the pandemic in terms of demand? Or have you seen anything different in terms of new types of buyers who may not have been in the market before?

So you're getting at the question of has there been a structural change in demand? And for those of you we've talked to before, it is my view that it is impossible to see true structural change coincident with that -- with the impetus for change. So to the extent there is a structural change, like there was post 9/11, I suspect it will take some time to play out. That said, I think I articulated the primary drivers of our frankly spectacular demand. We've certainly seen new buyers in the market. Some of that is the result of the increase in global wealth. Some of it is there were some significant wealth creation coming out of the pandemic. And also, as I said, the dissatisfaction with some airlines in business travel has increased. We've seen some new types of buyers. And frankly, as our stalwart Fortune 500 customers have -- are replenishing their fleet, they're doing so -- we've got more airplanes to offer them, but they're doing so across a wide panoply of models. So demand -- by the way, demand remains. The pipeline remains quite good.

Well, Gulfstream demand, I guess -- [ Yama ]. Do you have a question? Yes. And then we've got one behind you, too.

One question on sort of the industry. Leading up to 2007, 2008, the industry overproduced in terms of aircraft. How do you think about the risk of overproduction in the current demand environment?

So we were not guilty of that. We only produce airplanes for whom we have a buyer -- for which we have a buyer. So to the extent that people fell out of the backlog, that created some -- a handful of newly available airplanes. But we manage that extremely well. I've always been a big believer, don't build airplanes that you don't have a buyer for. You end up with white tails. White tails is, if I fly into Gulfstream, I see white tails, there's a problem. They don't do it. So I -- we will build the airplanes for whom we've got a reliable, steady, firm buyer. And oh, by the way, our backlog contains very few fractionals. I think that's an important distinction. These are real buyers with real money. And we've got some pretty strong contracts with good Ts and Cs.

Very good. I know we've got another question right behind you there.

Yes. Just inflation, supply chain, any sort of semiconductor issues? And then how will interest rates so effect the liability side with regard to pension fund? And any interest cost -- bonds that you need to refinance at some point?

So we're watching interest rates, as everybody else. Clearly, it's already had some of an impact on our pensions, although pensions for us have never been as significant an issue as there are -- as they are for others. As I noted, we've got some debt to pay down by the end of the year. We managed through that. And with respect to inflation, there are 2 ways to think about that. You can cover inflation with price increases. And to the extent that we're able to do that, particularly in our Aerospace side, we have. And on the defense side, our long-term franchise programs tend to have escalation clauses in them to cover inflation. So while I think inflation is an issue for all of us, right now, we think we can manage through that from everything we've seen.

I guess we're inside of 30 seconds here. So maybe to wrap it up with a quick one on another macro topic since we're talking about macro topics. Higher oil prices. On the one hand, you've got higher operating costs for business jet, but business jet customers are not always particularly sensitive to that. And on the other hand, higher oil prices create wealth and for certain customers in certain parts of the world. So I guess, when you think about the impact of higher oil prices kind of for Gulfstream, good, bad, neutral?

We haven't seen any impact.

Yes. Okay. And with that, we are right at time, so let's wrap up here. And Phebe, thanks so much for being here. We really appreciate it.

Well, thank you all for coming. Appreciate it. Thanks.