General Dynamics Corporation (NYSE:GD) Q4 2022 Earnings Call Transcript

General Dynamics Corporation (NYSE:GD) Q4 2022 Earnings Call Transcript January 25, 2023

Operator: Good morning, and welcome to the General Dynamics Q4 2022 Conference Call. All participants will be in listen only mode. Please note, this event is being recorded. I would now like to turn the call 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 fourth quarter and full year 2022 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 reconciliation 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 Web site, investorrelations.gd.com. With my introduction complete, I’d turn the call over to our Chairman and Chief Executive Officer, Phebe Novakovic.

Phebe Novakovic: Thank you, Howard. Good morning, everyone, and thanks for being with us. Earlier this morning, we reported earnings of $3.58 per diluted share on revenue of $10,850 million, operating earnings of $1,230 million and net earnings of $992 million. Revenue is up $559 million or 5.4% against the fourth quarter last year. Operating earnings are up $41 million or 3.5%. Net earnings are up $40 million or 4.2% and earnings per share are up $0.19 to 5.6%. So the quarter-over-quarter results compare very favorably and are in most respects consistent with our forecast and sell side consensus. The sequential results are even better. Here, we beat last quarter’s revenue by $876 million or 8.8%, operating earnings by $129 million or 11.7%.

Net earnings by $90 million or 10% and EPS by $0.32, a 9.8% improvement. As promised that it would be, the final quarter is our strongest for the year in both revenue and earnings. In fact, earnings per share, operating margins, net earnings and return on sales improved quarter over the previous quarter throughout the year. It was a nice steady progression of sequential improvement. For the full year, we had revenue of $39.4 billion, up 2.4%, net earnings of $3.4 billion, up 4.1% and earnings per fully diluted share of $12.19, up $0.64, a 5.5% increase. So overall, the year was also reasonably consistent with our forecast and modestly better than the sell side. It was a very solid year in a difficult environment. Let me ask Jason to provide detail on our overall order activity, very strong backlog and cash performance in the quarter and the year.

Jason Aiken: Yes. Thank you, Phebe, and good morning. Order activity and backlog were once again a very strong story with a 1.2:1 book-to-bill ratio for the company for the fourth quarter and a 1.1 times for the full year. Order activity in the Marine and Aerospace groups led the way. We finished the year with a total backlog at an all time high of $91.1 billion and total estimated contract value, which includes options and IDIQ contracts of nearly $128 billion. I should note that foreign exchange rate fluctuations continued to be a headwind, reducing year-end backlog by nearly $600 million with the vast majority of the impact in Combat Systems. Turning to our cash performance for the quarter and the year. It was another solid quarter with operating cash flow of $669 million, which brings us to $4.6 billion of operating cash flow for the year.

After capital expenditures, our free cash flow for the year was nearly $3.5 billion, a cash conversion rate of 102%, slightly ahead of our target for the year of 100% of net income. As discussed on previous calls, Gulfstream enjoyed particularly strong cash performance throughout the year on the strength of its order activity and the Technologies Group once again delivered outstanding cash performance. That said, when we talked with you in October, we discussed three potential constraints to cash in the fourth quarter; the pending outcome of congressional action on the tax treatment of R&D expenditures; the timing of resumption of cash collections on the Ajax program in the UK; and an anticipated uptick in capital expenditures as we progress through our ongoing facility investments.

As it turns out, the Congress did not act to remedy the requirement to capitalize R&D costs, we did not receive any payments from the UK, though we now expect payments to resume this quarter, and our capital investments were in fact elevated, consistent with expectations. I’ll discuss that in more detail a little later in the call. The net result was a lighter fourth quarter from a free cash flow perspective but slightly better than we had expected and rounds out a very strong year in terms of cash performance despite the headwinds I discussed. I should also point out that free cash flow per share has grown at a 22% compound annual growth rate from 2019 through 2022.

A – Phebe Novakovic: Thanks, Jason. Now let me review the quarter in the context of the business segment, paying modest attention to the quarter-over-quarter sequential and annual comparisons that are rather straightforward and set out in the press release. First, Aerospace. The story in aerospace is found in the sequential and year-over-year improvement as well as a continuing strong demand for Gulfstream aircraft, along with the overall strength of Gulfstream service business and the continuing improvement of Jet Aviation. In the quarter, Aerospace had revenue of $2.5 billion and earnings of $337 million. This represents a 4.4% increase in revenue and an 8% increase in earnings on a sequential basis. For the full year, revenue of $8.57 billion is up $432 million from the prior year, even though we delivered only one more aircraft than we did in 2021.

The increase in both revenue and earnings was driven by higher service revenue at both Gulfstream and Jet Aviation. Earnings were also helped by somewhat higher margins on delivered aircraft. Fourth quarter revenue and earnings comparison on a quarter-over-quarter basis are as attractive because three aircraft we plan to deliver in the fourth quarter slipped into the first quarter this year. Gulfstream had 38 deliveries in the quarter when we had planned to deliver 41. As a result, aerospace revenue and earnings are somewhat less than anticipated by the sell side for the quarter and for the year, but generally consistent with our forecast. I should also point out that Aerospace margins improved consistently quarter-over-quarter throughout the year.

Aerospace demand remained strong. The book-to-bill was 1.2 times in the quarter and 1.4 times at Gulfstream alone. Orders in the quarter were $3 billion, up from $2.7 billion in the third quarter. The aerospace book-to-bill for the year was 1.5 times. To give you a little more color, Gulfstream received 430 new aircraft orders over the past two years, over 400 net orders after default and backlog adjustments as a result of the settlement of a case in arbitration. All said and done, aerospace backlog is up 20% in 2022 and a staggering 68% over the past few years. As we go into the new year, the sales pipeline remains strong and sales activity is at a solid pace. At midyear 2022, we told you to expect revenue of about $8.6 billion and an operating margin of around 12.9%.

We actually finished the year with a 13.2% operating margin. In short, we were spot on with respect to revenue and 30 basis points better on operating margin, which led to a $25 million more than forecast in operating earnings. With respect to G700 development, we estimate it will certify this upcoming summer but much depends on available FFA resources. So far, the effort has been very collaborative and is proceeding according to plan with no surprises. In summary, aerospace exhibited very strong performance in the quarter and for the year. We look forward to a significant increase in deliveries in 2023 at Gulfstream and improved operating margin, but more about that as we get into guidance. We also expect continued growth and margin improvement at Jet.

Next, Combat Systems. After a relatively slow start to the year, Combat Systems finished with a powerful fourth quarter. In fact, the fourth quarter of 2022 proved the highest revenue and earnings for Combat Systems in over 10 years. Revenue in the quarter was $2.18 billion, and it’s up 15.5% from the year ago quarter. Operating earnings of $332 million are up 18.1% on a 30 basis point increase in operating margin. OTS alone captured more than one third of its revenue and earnings in the fourth quarter. The revenue growth was largely driven by Mobile Protected Firepower, Abrams for Poland and the large international order in Canada. OTS enjoyed higher revenue across all lines of business with particular strength in artillery rounds. Not surprising, the sequential comparisons are even better.

Revenue is up $391 million or 21.9% and earnings are up $61 million or 22.5% on the strength of a 15.2% operating margin. From an orders perspective, Combat had a very good year in 2022 with a book-to-bill of 1.1 times, driven by MPS, very strong international demand for the Abrams main battle tank as well as growing demand on the munition side of the business. By the way, Combat’s annual performance is fairly consistent with the forecast we provided you earlier in the year. Revenue and operating earnings are up somewhat and operating margin is a little lower. In short, this group had a wonderful quarter, continued its history of strong margin performance and had good order activity and a strong pipeline of opportunity as we go forward. Marine Systems.

The Marine Systems growth story continues. Fourth quarter revenue of $2,970 billion is up 3.4% over the year ago quarter. Revenue was also up 7.2% sequentially and 4.9% for the full year. Operating earnings are up about 1% over the year ago, off less than 0.5% sequentially and up 2.6% for the full year. Once again, this is the highest full year of revenue and earnings ever for the Marine group. A little perspective maybe of assistance here. Marine Systems has grown revenue from $8 billion in 2017 to $11 billion in 2022, this is a 5.3% compound annual growth rate with an average increase of $600 million per year. Earnings have grown from $685 million in 2017 to $900 million in 2022, a 5.5% compound annual growth rate. In addition, Marine had strong orders in the quarter, generating a 2.2 times book-to-bill, including the receipt of a $5.1 billion contract modification to Colombia.

Our forecast to you in July of last year anticipated revenue of about $10.8 billion, operating margin of 8.3% and operating earnings of $896 million. We came in above that for revenue, a little lower on the predicted operating margin and right on the forecasted earnings. So Jason is going to give you a little color on the Technologies group, his new responsibility, provide a bit of perspective on balance sheet, other income and expense items, and I will close with our outlook for 2023.

Jason Aiken: The technologies group as a whole had a very strong finish to a solid year and a very challenging operating environment. Revenue in the quarter of $3.25 billion was up 9.3% over the prior year and up 6% sequentially. Operating earnings of $340 million were up about 2% over the fourth quarter of 2021 and sequentially, were up an impressive 19%. The main driver of the fourth quarter performance was Mission Systems’ ability to overcome some of the logjam in its supply chain and deliver some of the product that was held up at the end of the third quarter. While these issues have not been completely resolved, the fourth quarter performance gives us good reason for optimism that they’re starting to see their way through this.

For the year, revenue of $12.5 billion was up just slightly from 2021. Breaking that down, GDIT once again grew in the low single digits, up 1.6% after 2.2% growth in 2021. Mission Systems was down 2% despite the strong end to the year. Earnings for the year of $1.23 billion were down 3.8% on a 40 basis point contraction in margin to 9.8% as a result of the mix shift between product and service revenue as GDIT reported its highest margin since the CSRA acquisition and its highest ever earnings, but Mission Systems was down for the reasons discussed. With respect to backlog, the Technologies group had a solid year, notwithstanding an ongoing trend of customer solicitations pushing to the right and recurring award protests. GDIT received over $11 billion in awards during the year, almost 20% higher than 2021, representing more new work than any year since the CSRA acquisition.

And Mission Systems finished the year with a 1.1 times book-to-bill and a capture rate in excess of 80%, putting them in a good position to emerge from the supply chain headwinds they’ve been facing. With that, I’ll turn to some of the financial particulars before turning it back over to Phebe to give you our guidance for 2023. Starting with capital deployment in 2022. Capital expenditures, as I noted, were elevated in the fourth quarter at $494 million or 4.6% of sales. That brings us to $1.1 billion for the full year. At 2.8% of sales, full year capital expenditures are slightly higher than our original expectation due strictly to timing. We expect capital expenditures to start to step back down below 2.5% in 2023 and continuing to trend towards historic levels.

Andrey Armyagov/Shutterstock.com

We also paid $345 million in dividends in the fourth quarter bringing the full year to $1.4 billion, and we repurchased approximately 440,000 shares of stock in the quarter, bringing us to over 5 million shares for the year for $1.2 billion at just under $226 per share. With respect to our pension plans, we contributed $50 million in 2022 and we expect that to increase to approximately $200 million in 2023. This includes a modest voluntary contribution to one of our commercial plans, which was made this month and fully funds the plan that had a funding gap of more than $500 million within the past two years. Concurrently, we shifted the investment mix to hedge the plan’s $2 billion of liabilities, thus eliminating any funding risk associated with market volatility or discount rate fluctuations.

However, as a result of the change in investment mix, our pension income will be lower in 2023. Following this derisking activity, we expect our corporate operating expense for 2023 to be approximately $140 million and our other income to be approximately $80 million, a combined reduction of roughly $125 million in nonoperating noncash income from 2022. Speaking of pension income, the fourth quarter had higher than anticipated other income as we benefited from higher discount rates for measuring liabilities on our nonqualified pension plans, which are mark-to-market at the end of the year. We also repaid $1 billion of fixed rate notes in the fourth quarter. After all this, we ended the year with a cash balance of over $1.2 billion and a net debt position of $9.3 billion, down approximately $600 million from last year.

We have $1.25 billion of debt maturing in 2023. Our net interest expense in the fourth quarter was $85 million, bringing interest expense for the full year to $364 million. That compares to $93 million and $424 million in the respective 2021 period. Pending our decisions with respect to the scheduled debt maturities, we expect interest expense in 2023 to remain essentially consistent with 2022. Turning to income taxes. We had an 18.1% effective tax rate in the fourth quarter, which brings our full year rate to 16%, consistent with our guidance. Looking ahead to 2023, we expect the full year effective tax rate to increase to around 17%, reflecting higher taxes on foreign earnings. The sum total of these below-the-line items versus the comparable levels in 2022 is a net negative impact on 2023 diluted earnings per share of $0.63.

And finally, with respect to our outlook for free cash flow, following a strong 2022, we expect cash conversion in 2023 to be better than 100%, roughly in the 105% range, assuming the resumption of Ajax receipts in the first quarter, as I mentioned earlier. That concludes my remarks. I’ll turn it back over to Phebe.

Phebe Novakovic: Thanks, Jason. So let me provide our operating forecast for 2023 with some color around our outlook for each of the business groups and then a company-wide roll-up. In 2023, we expect Aerospace revenue to be around $10.4 billion, up between $1.8 billion and $1.9 billion. Margin is expected to be up 140 basis points to 14.6%. Gulfstream deliveries will be around 145, up a little over 20%. This is all consistent with the multiyear forecast we gave you in January of 2021 and at the end of Q2. In Combat Systems, at this time last year, we had anticipated revenue to be down slightly in 2023, following a modest decline in 2022 with a return to low single digit growth later in our planning horizon. Since then, the threat environment has clearly changed.

Continuing the better than expected performance in 2022, we expect the group to hold steady again in ’23 with revenue of $7.3 billion and operating margin once again towards the high end of their reliable 14% to 15% range at 14.7%. The improved outlook is a result of strong order activity we saw in 2022, including the MPF award and growing international demand, particularly the tank order in Poland, which came in sooner than had been anticipated. We’re seeing demand signals resulting from the war in Ukraine, but we’ve only just begun to see that manifest in our backlog at this point. To the extent those demand signals start to convert into order activity, we could see some opportunity for additional revenue in the latter part of the year, particularly in our armaments and munition business.

As I noted earlier, Marine Group has been on a remarkable growth journey, averaging $600 million a year. Our outlook of $400 million to $500 million per year over time remains unchanged. However, the supply chain constraints of the Virginia program will drive some annual variability this year. As a result, the group’s revenue for 2023 will remain essentially flat at $10.9 billion as well their operating margin rate at 8.1%. We anticipate a return to growth in 2024 and 2025 at around $600 million a year. We expect revenue in the range of $12.5 billion to $12.6 billion in the Technologies group. To give you a little color behind this outlook, GDIT will continue to grow at a low single digit pace consistent with the past three years. Mission Systems, however, will be challenged from a revenue perspective.

Particularly in the first half of the year as they work through the lingering supply chain issues they’ve been dealing with for the past 18 months. As a result, their revenue will be down slightly compared with 2022. The resulting shift in the group’s revenue mix, with stronger service activity but lower hardware volume would yield an operating margin in the 9.5% range, sustaining their industry leading performance, albeit slightly lower than 2022. So for 2023, company wide, we expect to see approximately $41.2 billion to $41.3 billion of revenue, an increase of almost 5%. We anticipate operating margin of 10.9%, up 20 basis points from 2022. This all goes up to a forecast range of $12.60 to $12.65 per fully diluted share. On a quarterly basis, we expect a pattern similar to what we’ve seen in recent years with sequential increases in revenue and operating margins throughout the year.

As always, this forecast is purely from operations. It assumes we buy only enough shares to hold the share count steady to avoid dilution from option exercises. Beating our EPS guidance must come from outperforming the operating plan and the effective deployment of capital. Let me close with an observation. Our forecast comes from our operating plan. It is conservative as it must be in this environment of unpredictable financing of the government. However, the threat environment suggests increases in defense spending. In short, I see more opportunity than risk in our forecast. With that, I’ll turn it over to Howard to start the Q&A.

A – Howard Rubel: Thanks, Phebe. 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?

See also 22 Largest Hunting Companies in the US and 10 Best Healthcare Stocks for the Long Term.

Q&A Session

Operator: . Our first question comes from Myles Walton with Wolf Research.

Myles Walton: I was hoping maybe you could touch on a couple of things. One, Jason, your new role and how you sort of think about balancing the act between the CFO and the operating segment roles and responsibilities with you intend to focus on there. And then maybe on the capital deployment front for ’23 at 105%, obviously, you’ve got a lot of excess cash. Should we expect you to pick up repurchase activity in ’23 versus ’22 or relatively similar?

Jason Aiken: Myles, I think with respect to your first question, looking at the new responsibility and that opportunity. First and foremost, it’s important to remember that these businesses are run by two excellent and accomplished presidents. And frankly, I have the highest level of confidence in them and their teams. When I look back over recent history in this role, Chris Marzilli, really helps steer this business through a period of remarkable change and transformation, not to mention COVID. And I don’t think as I look ahead that this market is going to become any less dynamic. So I think the focus really is on continuing to make sure that the businesses continue to focus on their bottom line, earnings and cash as always but frankly, also finding our way to a sustainable top line growth trajectory, and that will really be the emphasis.

In terms of balancing the two, I’m humbled and honored to have this dual responsibility, fortunately entering my tenth year in the role as CFO. So I feel confident about the ability to handle both at the same time.

Phebe Novakovic: So with respect to our capital deployment, we’ll continue to invest in our business where prudent. We’ll continue to maintain our dividend and we’ll repurchase shares accordingly. So I don’t see any big change in the priorities at least for our execution.

Operator: Our next question comes from David Strauss with Barclays.

David Strauss: Phebe, could you touch on — you mentioned three deliveries that slipped out. Was that customer preference, was that supply chain related? And then it doesn’t appear that you’re going to — your prior guidance was 148 deliveries this year, now you’re talking 145. So it doesn’t seem any makeup there. And then last thing, the 170, I think you forecasted for ’24 deliveries. Does that still hold?

Phebe Novakovic: So let me go in order. We had, as I noted, three airplanes have slipped into this quarter. One was simply an issue that we just couldn’t get it completed in time and two of them were customer preferences for international deliveries. With respect to the production next year, we are confident that we can make that and our trajectory going forward past this year remains the same. So directionally and we’re right on track, and we’re comfortable we get there.

Operator: Our next question comes from Seth Seifman with JPMorgan.

Seth Seifman: I wonder if you could talk a little bit more about marine and the supply chain challenges at Electric Boat. And specifically, what we should be looking for in terms of any particular metrics, whether it’s hiring or deliveries or certain milestones to get a sense that things are firming there and kind of also what the risk is of further deterioration in schedules.

Phebe Novakovic: So let’s deconstruct that and I think we have to posit few truth. We went into COVID with scheduled variants on Virginia. Virginia is also about a third of the Electric Boat revenue. COVID had a profound impact on many aspects of our lives, but particularly lasting one on the workforce. We had labor discontinuity throughout the United States and we also experienced something that we had not anticipated abnormally large retirement of experienced workers. In a business that is heavily manpower dependent, these impacts had a disproportionate effect on additional schedule variants. We are working with the Navy who’s been quite active and engaged in helping develop a plan and a really detailed action list on how to address these issues and shipbuilding and the supply chain are fixed by incremental improvements over time.

So what do we see at the moment? We see stabilization in the workforce. I think across the nation, we’ve got a little bit better labor dynamics than we did immediately coming out of COVID. We also have additional experience in what some of the challenges have been. So the way I look at it, this year will give us a bit of a chance to dig further see funds to the velocity of the material coming into Electric Boat. And that ought to be a good thing for all involved despite and notwithstanding the considerable issues around schedules. I would note that the Submarine Industrial base for the two submarines last year, and we’re going to deliver two more this year. So I think maintaining that cadence of delivery is important. But in much of shipbuilding, milestones are difficult to identify really until you get the ship in the customers’ hands.

So as I said, we’re working very closely with the Navy to ensure that we could just get back some of that schedule variance on the remainder of the Block 4 ships and on the Block 5 ships.

Seth Seifman: And maybe just to follow up specifically on that. Most of the discussion — our discussion today and then the trade press has been about Virginia. How’s the Columbia schedule holding up?

Phebe Novakovic: So we’re about 30% done on the first ship and we are ahead of the contract schedule.

Operator: Our next question comes from Peter Arment with Baird.