General Dynamics Corporation (GD) Earnings Call Transcript & Summary

GD's CEO and Chairwoman Phebe Novakovic. Phebe, thank you for joining us. And so everyone starts with Gulfstream, let's change, let's start with combat.

Nobody talked about it for a while. But obviously, its relevance is increasing as a result of Russian invasion of Ukraine. You got a $3.6 billion proposed FMS tanks sale to Poland. Walk us through the order prospects for vehicles and when they might impact your business?

So the -- can everybody hear me? Oh! Howard is reminding me that administered [indiscernible] a forward-looking statement, I said it. And the details are available, I believe, on our website. So the threat environment has clearly changed. And that, plus the combination of MPF drove last year revenue a little higher than we had anticipated. So Abrams, light armored vehicles, labs and munitions and ammunition are all increased demand. That provides us the potential for some upside this year, depending how quickly contract execution happens. But we're anticipating relatively flat sales this year, low single-digit growth next year and then mid to low in the out years.

Okay. And can you give us a little bit more -- is it Eastern Europe? I think on the call, you mentioned around 6 or 7 countries that were looking at vehicles.

Yes. So I mean, it's a lot of Eastern Europe. The closer you are to the fight, the more you feel the threat directly. And so they've been a little quicker to execute their contracts to meet their requirements. Austria, Switzerland, Germany, Spain, Denmark, so really a good mix of future and existing customers.

So I think as people look at this area of the world has bought weapons before. And then we see $3.6 billion for the tank and then we see Poland coming forward with $10 billion for HIMARS and GMLRS et cetera. I mean could we see a surprise here? I mean it's very hard to sit on this side and get a sense of how big the potential could be? I mean you give us any qualitative sense of that?

Well, we certainly hear from our customers that they're interested, but it takes a while on that interest to materialize into funding and then contract action and the new ramp-up production. So I don't know that we have or anybody knows the maximum demand ultimately that will be driven as a result of invasion. But it's certainly -- we'll see higher percentage of GDP spending throughout NATO as well as Europe. So I think there is upside. But from our point of view, we'll just take it when it comes in small incremental increases to our portfolio.

And then the weapons area is around 25%, 30% of combat. It usually does not get much attention. It's been flat since 2019. Can you give us any sense as to where it might go over the next couple of years?

So I don't want to speculate but let me tell you what we do know. We have had interest in -- we want to see contracts materialize for increasing production in the existing capacity, and that's just increasing throughput. But in order to meet the demand, there's going to need to be investment and we're working very closely with our customer to ensure that the investment and contracting resources are available in order to meet this demand. And it is a very collaborative effort with the U.S. one.

So when you say you need investment, presumably that implies a multiyear ramp, it's not just going to be big in '24, it's likely to be several years.

So the -- that line of business, not just for us, but that funding line of business within the defense budget has been relatively flat to declining for some time. And there was a good [indiscernible] for that. And that is as the Army was upgrading and changing and modernizing several lines of munition, that funding got flattened in the moment and then the R&D had increased. So that's kind of why we have lived with this current industrial base that we have in the moment, really unchanged in the capacity that kind of deliver relatively unchanged for a number of years just because of that transition. That's all changed now. So we're moving very quickly as is the Army to increase investment, and then we can stand up these lines. And I think we will go faster than anybody anticipates.

So you've also got the 2 big foreign vehicle programs, AJAX and then Canada's international sale that have some problems over the years. Can you update us as to where you are on those?

So on AJAX, we -- customers continue to reiterate their support for the vehicle, and this is a very mature vehicle that we have great confidence in. But I don't want to get ahead of current events and activities prior to their being memorialized. With respect to the large international order out of Canada, that order is beginning -- the revenue on that is beginning to decline as we continue to deliver product that will be somewhat offset by increased sustainment over time.

Got it. So...

By the way, any -- the issues with respect to payment on that contract a couple of years ago have been fully resolved.

Right. So I believe the MOD in the U.K. came out with a report. I think it was in December saying that the noise and vibration issues that you have had around AJAX were essentially resolved. I think you've talked about the payments have resumed there. When should we assume basically the unbilled gets worked down on that program?

So I think what I have said is that we anticipate given maturity of the vehicle and where it is and its test program that payments will begin to flow again, but we're not going to be real specific about that other than we anticipate this -- largely this quarter.

Got it. So you mentioned on the fourth quarter call that Marine, particularly EB has been heard by the abnormally large retirement of experienced workers. And have you seen that trend start to abate at all? And what sort of threat does it still pose to your accrual rates on Virginia and Columbia?

So the submarine industrial base, not unlike the defense industrial base, experienced a higher than anticipated retirement level than we had expected prior to the pandemic. And that resulted in the shipbuilding industry, new shipbuilders, but also throughout the industrial-based new workers. At Electric Boat, we have a very mature training program. So we've been impacted far less than certainly most in the Marine Industrial base. And our new shipbuilders are coming down the learning curve very quickly. But that demographic change is impacted this year's revenue on Virginia, partially what it is contributing to relatively flat revenue in that -- for us in this year. But for Columbia, Columbia has the highest national security rating that the nation provides throughout the supply chain. So that program remains ahead of contract schedule.

Got it. Okay. And should we think that the trend there -- because the -- the retirement, is that continuing at that rate of the experience...

It has, for us, largely abated. So we don't anticipate seeing that for a while again.

So hopefully, looking forward, we should see a more normal cadence in terms of Marine revenues going forward.

So as I say, for us, it was a little bit of a stub of the tow, but not a trip. And we gotten our cadence back pretty well, but we need that entire sort of Marine supply chain to really stabilize. So that may take some time.

So Mission Systems, you've talked about being down for the third year in a row. And while GDIT sales and margins have increased for 3 years, can MS margins ever get back to where they were in 2021?

So Mission Systems was impacted by a shortage in several of their key parts and we believe -- we like where they stand right now in terms of recovering halfway through this year, but it remains a large item as you would expect with any very complex problem. But what gives us a considerable bit of confidence in where they -- how they are going to execute the remainder of this year is what they've done to prepare. So they have increased long-lead material purchases and they have worked with customers to redesign key components that simply will not be available within reasonable lead times. So kind of like where they are right now.

So if we look at this business...

By the way, but if we go back to your fundamentals, the predicate of your question, this product business has always been a strong margin performer. So we expect that their margins will again improve once we get through this supply chain challenges.

It sounds like -- because if we look at it, I mean, we've gone through 2 years where it kind of struggle a little bit, struggle a little bit more. It kind of sounds like now we're kind of at a bottoming and then hopefully, things will turn at some point.

We see that their margins improve. For the group margins, the change in mix from increased services in GDIT and lower hardware deliveries and issue systems change the group margin, quite naturally.

Right. So you account -- unlike others, you account for GDIT's margins after amortization, you don't basically take it out and say, here is what it is. We're really great. But theoretically, that amortization moves down. But -- so can the margins before amortization continue to improve?

So GDIT has increased its margins every year for the last 4 years, except during pandemic and where they held their own in terms of stability of their business. And last year, they had their highest margins ever. So I don't think there's anything really to fix here. We're very driven on margin performance.

Okay. Okay. So in the third quarter, you quietly bought another service provider Progeny in the tech sector. That's I think the largest acquisition you've made since CSRA. Is this the beginning of a trend? Are there more things -- and issues you'd like to fill in that sector?

So it was frankly the only acquisition and relatively small bolt-on for Mission Systems other than some service infrastructure -- aviation infrastructure companies that we bought for Jet Aviation. It's a nice bolt-on in the main line of business for Mission Systems, but it signifies nothing in terms of a change in our capital deployment structure.

Because I remember, Jason, I think, made a comment that as you look at that sector, all the other folks have been quite active in terms of M&A and getting big. And I know that you made the move with CSRA to sort of reassert your leadership position. So is it getting to the point where you think, or maybe you might need to do something else in that sector?

So we have invested in key technologies and capabilities that we think differentiate our products and our offerings to our customers, and we'll continue to do so where we see an ability to fully differentiate ourselves. I'm not going to get into M&A.

Okay. Okay. No surprise.

What a shock.

No surprise. So finally, turning to Gulfstream. So you mentioned on the fourth quarter call that R&D would start to abate toward the end of next year, and maybe I misread that. It sounds like that's a little later than you thought earlier in '22. So has there been any change in terms of the R&D profile, and maybe the cost of bringing the 700 and 800 to market?

So R&D will abate a bit post the certification of the 700 and 800, but it is important not to underestimate the commitment to upgrading our existing airplanes on a disciplined methodical manner, and as the market dictates, introducing new airplanes. So we may -- we'll see a slight reduction in R&D, but nothing significant. Let's remember, this investment has made Gulfstream what it is today. Before -- move away from that stream.

Rather. So you've got a big revenue lift coming at Gulfstream in '23 and '24. And if the R&D basically starts to even trend down very slightly after the 700 and 800, what kind of incremental margin should we be looking for there?

So nothing has changed in the margin and performance estimates with projections that we gave you, our multiyear projections. So we will manage this. We will come down, dedicated learning curves -- learning curves on dedicated lines on all aircraft. So Gulfstream has always been and will continue to be a very strong margin performance, but it's all factored into the estimates we gave you multiyears.

I can't remember what you said. I believe there was sort of less margin increase in '24. But I mean as I've looked at it, it looks like once you get out to '24, all these programs really are quite mature, and should be generating good profitability. And so if the R&D to sales tracks down, that there might be at least as much margin upside in '24 and '23. Am I thinking about it indirectly or the...

I think you are -- I think this is a very sophisticated, complex and multidimensional business when it comes to driving margins. But fundamentally, margin performance is based on operating excellence, and we have more than once proved that. So we're pretty comfortable in the estimates that we gave you.

Got it. So like others, you've seen delivery slips, not big ones, but little ones due to supply chain issues. Is that situation starting to stabilize?

So you're brilliant analyst, but I'm going to pick a nit with you on a word. It has never been unstable. So I think -- as you think about where we are headed, I suspect that we're -- we don't really see [Technical Difficulty] supply chain has been an issue. And it has been an issue for the last few years, but Gulfstream has done a superb job managing its supply chain, including embedding people within the supply chain to meet our throughput. But just to give you some perspective, we have 3 airplanes slipped from last year into this year, 2 were because of the customer preference and 1 was because we were not ready, not supply chain. So -- and all 3 have already delivered. They delivered last month. So it is a challenge managing this supply chain, but Gulfstream has done very well.

No, no, you have. And I think -- so partially where I'm going with this is that when you have challenges to overcome, sometimes work gets done out of sequence, and it gets done, but it's not quite as profitable as if everything is flowing smoothly. So are we at a point where things are starting to flow more smoothly where the challenges of supply chain are abating?

I'd say that supply chain challenges remain pretty much the way they are. Gulfstream has been very good in optimizing those margin, optimizing its operational workflow. But of course, there's more work to do here. But we do not see that impacting again, our long-term estimates.

Okay. And so 1 of the big questions really that people ask about Gulfstream bizjets overall is, are we going to go into a cycle and customer buying habit patterns seem to be changing since the pandemic began, more high net worth individuals, more first-time buyers. So maybe characterize what you've seen at Gulfstream in terms of changes, if any, in the buying patterns? And what do they suggest about cyclicality? I know that your sector of the business has much less cyclicality than others, but how should we think about those issues?

So when the demand picked up post pandemic in the first quarter of '21, we saw a few more high net worth individuals and a few more new buyers. But I do not see any systemic change. I cannot discern any real change in customer buying habits or patterns. We just have more of the same of every category of customer. So looking forward on Gulfstream demand, the pipeline is good. Our sales activity is good. We can anticipate and do a 1:1 book-to-bill for this year, given the duration and strength of our backlog. But I think it's really important to remember that our '23 and '24 estimates about production levels and delivery levels are independent of current demand. They are based entirely and solely on our strong durable backlog. So we even were there a macroeconomic perturbation. The next few years are solid for us.

Got it. So 1 of the things that others have mentioned is that over the past year, there have been more first-time buyers, people who have not owned a bizjet before. And some of that's being stimulated by the fractionals. Are you selling more to the fractionals or using them more or -- how should we think...

So I think it's an assumption and not necessarily provable that incremental first-time buyers would be driven by fractional use, but it's certainly a possibility. But for us, I mean, that's just on the theoretical basis of this. But for us, Fractional is an extremely small part of our business. We have never been able to align our business models and our interest with theirs. And that's been true for a long, long time. So by definition, they're very, very small part of our business and our backlog.

Got it. So you've talked about cash flow conversion. This year, 105% of AJAX payments resume and Gulfstream book bill holds at 1. Do you think those 2 assumptions -- or you're at all concerned about those assumptions?

Well, I think in a year of execution, you're always mindful of all the elements that contribute to cash, but we see -- we're very comfortable with our estimates for the year.

Got it.

And by the way, you should see for the foreseeable future, we do expect to have very efficient cash conversion rates, as I said, for the foreseeable future.

Well, if I go back to history, I think I can remember years when you -- because you have businesses with higher margins than others, that you've had fairly greater consistency than others in being at about 100%, not every year, but just over time. So as we look to '24, I assume the [ adject ] on bills will start to come down. Section 174 impact eases. CapEx presumably comes down. Any offsets that would prevent cash conversion from staying at or above 100%?

No, not that we see. We're largely through our investment period. So we expect to see that efficient conversion of cash, cash rate and we're quite comfortable. We can meet that. It tends to be something that we consider a competitive advantage and a key to driving value creation is focusing on cash, is all that matters at the end of the day.

Yes, right. So I mean -- so is there a chance you could be going back the next couple of years to kind of the 100-percent-ish type of -- I mean it sounds like next year, you could be, but in that...

I think you'll continue to see us perform at that level.

Got it. And so the other big question people ask is what happens with the cash, your balance sheet has been getting better? How do you think about the deployment?

So we've always been very opportunistic about capital deployment as we see opportunities arise that make sense to us, we execute accordingly. But just to step back, and I think maybe undergirding your question is when we look strategically across our business, we like the positioning of our 4 groups. They're strong. They're well positioned in their respective margins. So we do not have a strategic compulsion for any major changes in that regard, but we'll continue our opportunistic capital deployment where we think we can and we'll execute along the basic principle that -- where we can get the largest return on that investment.

Got it. Would you -- I mean Nick wants, your predecessor, want Gulfstream, [ which got you ] into a new area. Is there any thought -- because it looks like your current areas, you don't need anything to make them stronger. Would you consider a fifth leg to the stool?

So we have gotten that question for about 22 years because we have managed Gulfstream extremely well. In fact, we have added considerable value over the years. And so Gulfstream was almost a unicorn. It's extremely hard to find something that a defense -- a product that a defense company could add so much value to over time other than a Gulfstream. So as I say, I think we're quite comfortable. I -- we have thought very creatively about, is there anything else out there in 20 years, we haven't found it.

So I think, which I would say probably the cash goes to shareholders. I mean 100% going to shareholders is likely in the future.

Well, let's see, you have made an enormous leap of faith there. I think what we will do is continue to invest in our business to support our customers as we always have. Just at lower levels in the last few years where we had significant strategic investments across our portfolios. But we will look very carefully at our dividend. We have maintained a strong dividend over the years, and we'll be opportunistic about everything else that we consider.

When you say opportunistic, [ usually ] want shares when people weren't looking, so to speak, you've never considered an ASR. Is something would you consider an ASR at any point? Or is that something you're less likely to...

So just as a matter of principle, I prefer having control.

Okay.

And I don't want to bid against myself in the market. So it's tended to keep us away from ASRs. I think shareholders might like it in the moment, but I don't think that is necessarily that ensures the best possible return.

Terrific. Well, this has been great. So if we sort of to wrap up, if we look at your growth this year and next year, what are the key risks and opportunities? Like obviously, I think we've talked about some of the opportunities like combat maybe is going to be doing better. But as we go around the horn, maybe help us understand what could go better? And also, what are the things that maybe create a little more worry?

So it is important to have a radar on constantly looking for both the risks that are known and that typically in our defense and aerospace company is -- could be operational risks or right now, it's the supply chain. The supply chain in both aerospace and defense and we need to continue to work that. And so far, we have, but it is a real issue, and we've talked about it with respect to shipbuilding in particular. So we continue to work that. It's the unknown unknowns. You can walk through life having a healthy level of paranoia. But sometimes the things that are -- it's the things that sometimes gets you that you had not fully anticipated like a pandemic. Worldwide pandemic, who could have contemplated that and the impact that, that had and the responses of the various nations on the worldwide economy. But the key in any of those instances is just a management philosophy is to act quickly, agilely, correctly and adjust to whatever environment, and I think this leadership team has done a very good job doing that over time. So I think in the moment, it's supply chain. I think demand is constant and as best that we can tell. And we'll just continue to work those things that we know. And as I say, it is largely supply chain.

Now you mentioned that. And last night, we had a dinner with a couple of the [ Mackenzie, Igland, ] and others to talk about what's happening with the federal government and funding the budget, et cetera, et cetera. And I follow the services area. And there, there's been a lot of concern about not enough contracting officers and kind of erratic flows among some of your competitors in terms of the book-to-bills. How do you think -- you mentioned the demand side is okay, but what kind of concerns or issues should we think about for your business in terms of the budget and where you stand?

So the federal government and the defense department was not immune, suffered the same kind of labor-market perturbation that the rest of the economy saw. They need to recover that, that will help with contract velocity for sure. And so I think that, should that get worse, that would clearly impact all of us, but as best I can tell from talking to the acquisition community of our various customers as well as the Office of Secretary of Defense that for them, they're -- some of their hiring challenges seem to be getting a little bit better. So I don't anticipate that getting worse. And we have factored in the long delays in execution of contracting into our projections.

And what about the Republicans versus the Democrats and the defense folks persisting budget hole.

So look, I've learned over the many, many years of watching the defense budget that all that matters at the end of the day is what comes out in the bill. And it's less about party than it is about national security and threat. And irrespective of party, when the threat increases, the Congress has responded. So I don't see that fundament -- that basic operating principle of our government fundamentally changing despite whatever drama there may be, your concerns or antipathy or the far left and the far right become increasingly extreme, we still have a strong middle that rallies in defense of the nation.

Terrific. This has been great. So any final thought we should think about, about GD in the coming years?

So I think over the past few years, we have invested in our portfolio in R&D for our customers. That has helped our competitive advantage and particularly with respect to meeting the needs of our customers increased demands. We've put considerable CapEx into the shipyards to support the nation's need for more surface assets as well as submarines. And I think that, that's important. There is a covenant that we have with our customer to adequately and properly fund the elements of capital as well as R&D to ensure that we are able to provide for their needs and their requirements and the demand signals, but we also have to execute well. And we have had a long history of executing better than most, if not everyone, in our respective markets. That operating discipline is critical to driving real value for our customers as well as our shareholders.

Terrific. Thank you very much.

Good to be here.