General Dynamics Corporation (NYSE:GD) Q2 2023 Earnings Call Transcript

General Dynamics Corporation (NYSE:GD) Q2 2023 Earnings Call Transcript July 26, 2023

General Dynamics Corporation beats earnings expectations. Reported EPS is $2.75, expectations were $2.56.

Operator: Good morning, and welcome to the General Dynamics Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Howard Rubel, Vice President of Investor Relations. Please go ahead.

Howard Rubel: Thank you, operator, and good morning, everyone. Welcome to the General Dynamics second quarter 2023 earnings conference call. Any forward-looking statements made today represent our estimates regarding the Company’s outlook. These estimates are subject to some risks and uncertainties. Additional information regarding these factors is contained in the Company’s 10-K, 10-Q and 8-K filings. We will also refer to certain non-GAAP financial measures. For additional disclosures about these non-GAAP measures, including reconciliations to comparable GAAP measures, please see the press release and slides that accompany this webcast, which are available on the Investor Relations page of our website, investorrelations.gd.com. On the call today are Phebe Novakovic, our Chairman and Chief Executive Officer; and Jason Aiken, Executive Vice President, Technologies and Chief Financial Officer. With the introductions complete, I turn the call over to Phebe.

Phebe Novakovic: Thank you, Howard. Good morning, everyone, and thanks for being with us. Before I discuss the quarter, I want to take a moment to acknowledge the loss of our long-time Board member and Lead Director, Jim Crown. Jim has a record of distinguished service on the GD Board for over 35 years. Throughout that time, Jim provided guidance to more than five different management teams. We mourn his passing, and our prayers are with his family. Earlier this morning, we reported earnings of $2.70 per diluted share on revenue of $10.2 billion, operating earnings of $962 million and net income of $744 million. We enjoyed revenue increases at each of our four business segments. Importantly, we had a 12% revenue increase across the Defense segments, with a more modest 4.6% increase at Aerospace.

While revenue is up by $963 million or 10.5%, operating earnings are down $16 million and net earnings are down $22 million against last year’s second quarter. So, we had significant revenue increase but lower operating margin against the year-ago quarter. From a different perspective, we beat consensus by $0.14 per share on significantly higher revenue and modestly lower operating margin than anticipated by the sell side. The earnings beat was exclusively operations-driven. We enjoyed very nice sequential improvement. Revenue was up $271 million, and operating earnings are up $24 million on identical operating margins. On a year-to-date basis, revenue of $20 billion is up $1.45 billion or 7.8% over last year’s first half. Operating earnings of $1.9 billion are up less than 1% and net earnings are down $22 million, largely as a result of below-the-line items, including a higher provision for income taxes.

As Jason will amplify, cash from operating activities and cash after capital expenditures in the quarter continued at a very good pace. For the first half, free cash flow was 123% of net income. Obviously, we are off to a very good start from a cash perspective. As is clear from the press release, we also had a powerful order quarter across the business, extending our already large backlog. Jason will provide full color around that item as well. In summary, this is from a revenue perspective, a very strong quarter and a good first half. Supply chain issues and past COVID labor issues have impacted operating margins, but there is relief in sight. We expect improvement as we progress. At this point, let me ask Jason to provide some detail on our strong order activity, growing backlog and very strong cash performance as well as commentary about the Technologies group in the quarter.

Jason Aiken: Thank you, Phebe, and good morning. We had a very good quarter from an orders perspective with an overall book-to-bill ratio of 1.2:1 for the Company. Order activity was strong across the board, as each segment had a book-to-bill of 1:1 or greater in the quarter. This is quite impressive in light of the strong revenue growth. Combat Systems and Aerospace did particularly well with book-to-bills of 1.4 times and 1.3 times, respectively. This led to record-level backlog of $91.4 billion at the end of the quarter, up 1.7% from last quarter and up 4.3% from a year ago. Our total estimated contract value, which includes options and IDIQ contracts, ended the quarter at more than $129 billion. Turning to our cash performance for the quarter.

We generated $731 million of operating cash flow, which, following our strong first quarter performance, brings us to $2.2 billion for the first six months of the year. After capital expenditures, our free cash flow was $519 million for the quarter and over $1.8 billion year-to-date, yielding a cash conversion rate of 123% for the first half. This conversion rate reflects continued strong cash performance in Aerospace and Technologies and a particularly strong start to the year for the Combat Systems group from payments received on our large international vehicle programs. The year-to-date results are consistent with our expectation for the year of a cash conversion rate in excess of 100%. Now turning to capital deployment. Capital expenditures were $212 million, or 2.1% of sales in the quarter, which brings us to 1.9% of sales for the first six months.

Similar to last year, you should expect capital expenditures to be higher in the second half of the year, but in line with our expectation to be just under 2.5% of sales for the year. Also in the quarter, we paid $360 million in dividends and repurchased approximately 1.4 million shares of stock for $288 million. That brings year-to-date repurchases to 1.8 million shares for $378 million. We also repaid $750 million of debt that matured in May and ended the quarter with a cash balance of over $1.1 billion. That brings us to a net debt position of $8.6 billion, down nearly $700 million from year-end. As a reminder, we have an additional $500 million maturing in the third quarter that we plan to repay with cash on hand. Our net interest expense in the quarter was $89 million compared to $95 million last year.

That brings the interest expense for the first half of the year to $180 million, down from $193 million for the same period in 2022. At this point, our expectation for interest expense for the year remains unchanged at approximately $360 million. Finally, the effective tax rate for the quarter was 16%, bringing the tax rate for the first half to 16.5%. There’s no change to our outlook for the full year of approximately 17%. But of course, that implies a rate in the mid-17% range for the second half of the year. To shape that for you, we’d expect the rate to be somewhat lower in the third quarter and higher in the fourth due to typical timing items. Now turning to operating performance in Technologies. It was another solid quarter with revenue of $3.2 billion, which is up 7% over the prior year and continues to build on the strong start to the year we saw in the first quarter.

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In fact, each business grew year-over-year, both in the quarter and the first half. The measures implemented at Mission Systems to overcome what seems to be the new normal in the supply chain are taking effect. So we feel good about their prospects for the balance of the year. GDIT had another solid quarter, in fact, their highest second quarter revenues since before the pandemic as they continue to deliver on their steady year-over-year growth trajectory. Operating earnings in the quarter were $283 million, yielding a margin of 8.8%. As you know, margins are driven by the mix of IT service activity and hardware volume, and in this case, were further impacted by the mix of new start programs that are driving the strong growth trajectory. Backlog grew during the quarter, with the group achieving a book-to-bill ratio of 1.1:1 on solid order activity that outpaced the strong revenue growth across the business.

In fact, GDIT booked the highest first-half orders they’ve seen since mid-2019, and their pipeline remains robust with $20 billion in submitted bids awaiting customer decision and another $81 billion in qualified opportunities identified. Now, let me turn it back to Phebe to review the other business segments and give an update on our guidance for 2023.

Phebe Novakovic: Thanks, Jason. Now, let me continue to review the quarter in the context of the other business segments and provide color as appropriate and guidance for the full year. First, Aerospace. Aerospace had revenue of $1.95 billion and operating earnings of $236 million with a 12.1% operating margin. Revenue was $86 million more than last year’s second quarter on the strength of additional new aircraft deliveries, coupled with higher Gulfstream service center volume, partially offset by less volume in Jet Aviation’s completion center. The 24 deliveries are modestly fewer than planned and are a result of supply chain issues. On the good news side of the equation, supply chain conditions are improving. We still have a significant backlog of late parts, but processes are in place to catch up, deliveries are trending positive and we have greater transparency.

In short, the suppliers are more predictable and are complying with catch-up schedules. This will help both revenue and margins as we do less out-of-station work. Operating earnings of $236 million are $2 million behind last year’s second quarter as a result of a 60 basis-point reduction in operating margin. Operating margin in the quarter was off largely as a result of the supply chain issues and higher R&D expense. The shortage of parts continues to cause significant out-of-station work, impacting efficiency. As mentioned earlier, we see improvement here, and that should help as we go through the second half. Sequentially, Aerospace had a 3.2% increase in revenue and a 3.1% increase in operating earnings on identical operating margins. Moving to the demand environment.

Aerospace had a very good quarter with a book-to-bill of 1.3:1 in dollar terms and even higher for Gulfstream aircraft alone. Vibrant sales activity and strong pipeline replenishment were evident in the quarter. The U.S., particularly large corporations, led the way with the Mid East and Asia participating to a lesser degree. The 700 flight test and certification program continues to progress. The aircraft design, manufacturing and the overall program are very mature. However, we now target certification in the fourth quarter and see no major obstacles in our path. To give you a little more insight, we will complete our FAA Type Inspection Authorization in September. This is a flying we are required to do pursuant to FAA requirement and plan.

When we are finished, the FAA will fly some confirmatory flight tests to verify portions of our results. That will be followed by a brief period of paper submission, followed by FAA review. As most of you know, we had planned to deliver considerable number of G700s in the third and fourth quarters. That has now flipped into the fourth quarter. We now expect to deliver 27 aircraft in the third quarter, with a rapid increase in the fourth quarter deliveries. In short, we are making good progress under difficult circumstances. However, we expect to deliver 5 to 6 fewer aircraft than the 145 we forecast at the beginning of the year. On the other hand, we expect more service revenue than initially anticipated. I’ll have more on this later in my remarks.

Next, Combat Systems. Combat had revenue of $1.92 billion, up a stunning 15.5% over the year-ago quarter with growth in each of the business units. Earnings of $251 million are up 2.4%. Margins at 13% represent a 170 basis-point reduction over the year-ago quarter. So, we saw powerful revenue performance, coupled with more modest operating margin, in large part attributable to mix. The increase in revenue came from international vehicle programs at both Land Systems and European Land Systems. OTS has also enjoyed higher artillery program volume, including programs to expand production capacity for the U.S. government. These programs carry dilutive margins, but will result in more production at accretive margins over time. On a sequential basis, revenue is up $168 million or 9.6%, and earnings are up $6 million or 2.4% on a 100 basis-point reduction in margin for the reasons described.

Year-to-date, revenue is up $339 million or 10.1%, and operating earnings are up $24 million or 5.1%. We also experienced very strong order performance. Orders in the quarter resulted in a 1.4:1 book-to-bill, evidencing strong demand for munitions and domestic combat vehicles. International programs also contributed to the strong book-to-bill. So, a very exciting first half for Combat. Turning to Marine Systems. Once again, our shipbuilding group is demonstrating impressive revenue growth. Marine Systems revenue of $3.1 billion is up $408 million, a robust 15.4% against the year-ago quarter. Columbia-class construction and engineering volume drove the growth, and to a lesser degree, TAO growth. Operating earnings are $235 million, up $24 million over the year-ago quarter, with a 30 basis-point decrement in operating margin.

We anticipate that all of our yards are now well positioned for slow but steady incremental margin growth over time with fewer perturbations. On a sequential basis, revenue was up $67 million or 2.2%, and operating earnings are up $24 million or 11.4% on a 60 basis-point improvement in margin. For the first half, revenue was up $749 million or 14.1% and earnings are up $24 million or 5.7%. So, a good quarter and first half. So, let me move on to give you our updated forecast for the year. The figures I’m about to give you are all compared to our January forecast, which I won’t repeat. There is, however, a chart with respect to all of this, will be posted on our website, which should be helpful. In Aerospace, revenue will be down almost $200 million due to the 5 or 6 fewer aircraft deliveries, offset in part by stronger service activity.

So look for revenue of $10.2 billion. We also expect margins to be down from a projected 14.6% to 14.1%. This implies operating earnings of $1.4 billion. With respect to the Defense businesses, Combat Systems will have revenue of $400 million to $500 million higher than previously projected due to new program starts and an increased threat environment. So look for the total revenue of around $7.75 billion. Margins will be down 50 basis points from 14.7% to 14.2% on mix. All-in, operating earnings will be up $25 million over the previous forecast. Marine Systems revenue should be up $900 million or $1 billion on acceleration of work throughout the yards. This is a leading indicator of improving efficiency. So, we will have annual revenue around $11.8 billion with an operating margin around 7.6% for the reasons I have previously described to you.

Operating earnings for the year should be up $20 million over the previous forecast. Technologies revenue will be $100 million to $200 million better than previous guidance, but operating margin will be 9.4%, 10 basis points lower than previously forecast. So for the group, we expect annual revenue of about $12.7 billion, with operating earnings around $1.2 billion, steady with prior guidance. There is some opportunity here to capture 10 to 20 basis points of margin. On a company-wide basis, we see annual revenue higher than our initial guidance and an overall operating margin about 40 basis points lower. So look for total revenue to be around $42.45 billion, about $1.2 billion up from previous guidance. Operating earnings should be down modestly from prior guidance, but below-the-line items and lower share count will leave our EPS guidance the same.

One final note before I conclude my comments. Howard has informed the Company that he intends to retire later this year. So, this will be his last earnings call. We are grateful for the excellent work that Howard has done since joining our team. I hope many of you will join me in congratulating Howard on a job well done. Nicole Shelton, whom some of you know already, will be taking over the mantle with the third quarter call. That concludes my remarks, and we will be happy to take your questions.

Howard Rubel: Thank you for your kind words and friendship. It’s been a pleasure and a great experience to have had the opportunity to represent General Dynamics to the investment community these nearly six years. I have grown working side by side with many of the talented people of this tremendous enterprise. I look forward to working with Nicole over the next few months to ensure there are proper introductions and a seamless transition. There will be time ahead to say goodbye, but today, I want to say thank you. Now, let’s turn to the question-and-answer period of this call. As a reminder, we ask participants to ask one question and one follow-up so that everyone has a chance to participate. Operator, could you please remind participants how to enter the queue?

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Q&A Session

Operator: [Operator Instructions] Your first question comes from the line of Seth Seifman from JP Morgan.

Seth Seifman: Hey. Thanks very much. Good morning, and congratulations, Howard. Thanks for everything. Just on the new Aerospace guidance, I guess, maybe if you could walk through how you thought about the setup for that. And I appreciate that this is mainly a timing issue and that any airplanes that don’t get delivered in ‘23 can kind of move to ‘24. But just kind of the way we get level set. With 27 deliveries in the third quarter, we’re talking about something quite high to get to 140-ish for the year. And also, I mean, with 27 deliveries, I assume we’ll be looking at a margin in Q3 that’s probably still in the 12s and so also getting to 14.1% for the year. Maybe you can talk a little bit about the margin — the initial margin accretion from the new aircraft and what that contribution will be to the total deliveries.

Phebe Novakovic: Yes. So, I think you’ve put your finger on a nub of an issue. So, what we have given you with respect to Aerospace is Gulfstream’s plan, and the guidance that we gave you reflects their plan. Our January guidance, just for context, contemplated a very high Q4 delivery rate. That rate increased with the certification delay on the 700. 700 will be fully built and ready for delivery. Remember, too, our new planes are all built in purpose-built facilities. We’ve expanded our wing line. In short, we’ve facilitized for increased production. And finally, the fact that we have planes — and you can see this from the increase in inventory that are awaiting parts, we now have a schedule, and all of that taken together allows us to — will give us the ability to deliver.

With respect to margin, we’ve got a number of higher-margin airplanes, as you would expect, delivering in the fourth quarter. So, that provides significant uplift. So, we kind of explained how we intend to get the revenue through the deliveries, and the margin is really a question of mix of higher deliveries of higher-margin — greater deliveries of higher-margin airplanes.

Seth Seifman: Okay. And just a follow-up real quick on this topic. The 27 deliveries in Q3 would be down year-on-year. And so in terms of — there’s the issue of the G700 certification, which we’re all kind of looking at and it’s hard to analyze. But just for the non-G700 deliveries, is there any risk around what the plan was there and what Gulfstream expects to do?

Phebe Novakovic: So, as I noted in my remarks, our supply chain is increasing its transparency, improving its processes. And we have reliable — increasingly reliable schedules. That said, they’re more likely — likely to anticipate more catch-up in the fourth quarter, which will allow us to complete a number of those airplanes, but they’re still impacting the third quarter deliveries.

Operator: Your next question comes from the line of Robert Stallard from Vertical Research.

Robert Stallard: I can’t believe Howard’s retiring. He’s so young.

Phebe Novakovic: That’s what we say.

Robert Stallard: Anyway, I’ve got a couple of questions for you, Phebe. First of all, on the revised Aerospace guidance, you mentioned that you’ve increased your expectations for services for the full year. I was wondering if you could square this with what we’ve been seeing in Biz Jet flight hours year-to-date, which have been down year-on-year. And then secondly, a great Combat Systems order quarter, but how do you expect these orders to flow through to revenue growth over the next couple of years? Thank you.