General Dynamics Corporation (NYSE:GD) Barclays Industrial Select Conference Call February 22, 2023 8:35 AM ET

Company Participants

Jason Aiken - CFO

Conference Call Participants

David Strauss - Barclays

David Strauss

Thanks, Jason, for again being here in Miami. And I'll turn it over to you for the necessary disclosures, disclaimers.

Jason Aiken

Sure. Thanks, David, for having us today. As David mentioned, of course, today will involve inevitably some forward-looking statements, which always bring risks and uncertainties. So I advise people just to check on our filings with the Securities and Exchange Commission for risk and uncertainties [indiscernible].

Question-and-Answer Session

Q - David Strauss

All right. So I guess pulling up on my introduction, your new role. How are you? How are you feeling your time between the CFO role and SVP of Technology [indiscernible] for the year? And I guess, what are your near-term and longer-term objectives for Technologies?

Jason Aiken

Yes. So I guess the first thing I'd say is it's an honor and a privilege to have this opportunity with the expanded role. It's certainly humbling to get a chance to put on both of these hats at the same time, and looking forward to all the opportunities it presents.

I think as I look at the Technology group at a macro level and my objective is to work with these 2 business unit presidents and their teams to maintain our leadership position in a market that is very dynamic and continues to transform over time. And that includes a number of the peer comparator companies in this industry sort of morphing over time through acquisition and our needs to like more our technologies group looks like today. And so our goal is to keep stay ahead of that curve and to keep the leadership position within the group.

I think near-term priority would be into the -- the 2 businesses between GDIT and Mission Systems are on slightly different trajectories right now. So for GDIT, they've been demonstrating high, steady growth for the past couple of years, and so we want to keep them on that growth trajectory and continuing to press for accelerated growth on the top line, but more importantly supporting the continued bottom line growth.

At Mission Systems, they've been coming through some challenges post COVID with supply chain, and the near-term objective is to see them through to the other side of that. I think they've got very nice growth potential once they can come through those issues in the back half of this year. So that's sort of the near-term focus.

But longer term, it is continuing the unwavering drumbeat on the bottom line, growing earnings and cash performance of the business. At some point, that does require top line growth in a sustainable and accelerating level because you can only bring margins for so long, so we're going to work that in combination. I think that includes increased opportunity for these 2 businesses to go to market together. That's the way their peer group is behaving, that's the way the customers are procuring, and so I think we've got some great opportunity there.

You talk about the dual hats, the year has been off to a fast pace as you'd expect, certainly it's a finance-heavy time of the year. And at the same time, rolling up the sleeves and getting deeper involved into the new role in the 2 businesses. I would tell you that I am less to have a very experienced and very talented finance organization, both in my corporate staff as well as in the finance community around our operating units. And I would tell you the strength of that community, I think, is key to making this possible and giving me this opportunity. Without them, this would be a much more daunting challenge. So -- but excited for the opportunity ahead.

David Strauss

Want to move to Aerospace. So you guys seem like you've managed supply chain and inflation pretty well. We don't hear that much from you all with regard to both those issues that are obviously impacting the entire industry. Maybe touch on both there, are you seeing improvement in supply chain? How are you dealing with inflation? Are you getting that positive price?

Jason Aiken

Yes. Look, I appreciate the recognition there, frankly. Not for the leadership of the company, but for the leadership at Gulfstream. They continue to do things that are remarkable when it comes to all aspects of their operations, including the supply chain. You even saw that before the impact of COVID and what has been hitting a lot of other companies. There were some high-profile incidents whether it was wings on the G650 and the cells on the G500 and 600, they have demonstrated, I think, quite capably our ability to manage supply chain and even bring some of that in-house when necessary. It's active engagement with those suppliers.

And it sounds maybe a little bit overly simplistic, but it's easier said than done. It really is fundamentally a relentless focus on that operating excellence. The daily drumbeat, and I've learned this from these guys at Gulfstream in particular, as well as around other parts of our company. It is a relentless daily drumbeat of management on the shop floor, leadership of the people doing this work and making that happen. It's an attitude that says we will find a way. Doesn't mean you don't stumble occasionally, but we will find a way and darn it if they haven't proven again and again that they can do that.

So what I would say is it continues to be an issue. It's not. I mean, we're dealing with supply chain and perturbations just like everybody else is. There are -- the part count that shows up late to do on dock is still elevated as it's been throughout this COVID period, and some of that tends to cause the manufacturing team to shift the way they manage the aircraft assembly. Some things get done out of station, and of course, that can have an impact on efficiency. So we're looking forward to kind of hiring that out and improving the impact there so that we can bring out more efficiency in the production of the airplanes. But I have no doubt that, that team at Gulfstream can manage through that.

When you look at inflation, it is real for us as it is for anybody else. It's a factor that's out there. We're likewise managing through that. I would tell you that, you kind of alluded to it where it has a favorable pricing environment for us. So we've been able to keep ahead in that regard. And frankly, again, when you think about just the operational efficiency and continuing to come down learning curves on these aircraft model manufacturing lines, the combination of those 2 things has helped us stay ahead of the inflation gain. So notwithanding some inefficiencies out of the supply chain and inflationary pressures, we're still able to put forth, call it, low 20% incremental margins as we grow this business, and we'll look to continue to improve that over time.

David Strauss

I'll follow up on that in a second. But I guess, first of all, the delivery cadence. I think it was sometime last year, you put out your 3-year forecast for deliveries. You're a couple short last year, I guess, you're going to be a couple of short [indiscernible] nitpicking, but a little short this year, but you still have this big $170 million target out there for 2024. Is that still realistic? How are you tracking to that? And maybe talk about how important the G700 service is to making all this happen?

Jason Aiken

Sure. Obviously, the G700 certification timing and entering the service is fundamental to this ramp, right? And we can talk a little bit about what that timing means. But I think when you look at the overall projections that we gave and the direction we were taking this business, what's going to constrain us and what's going to be sort of the gating item during that process, going back to your earlier question, is the supply chain. If we can keep the supply chain along, that's going to allow us to get the step function increases in growth this year and again next year.

I think the important takeaway for me in that point is that probably for the first time, certainly since General Dynamics has Gulfstream, call it, the last 25-ish years. that multiyear outlook is not gated by current market demand order activity. We obviously are still assuming a roughly 1:1 order book to bill, but those outlooks we've given -- the reason we have confidence in that is because that's in the order book, that's in the backlog, and we are prepared to deliver on that. Again, subject to the supply chain being able to support that. So I think that's the most important takeaway for me.

To focus on the little nitpicking that you mentioned, okay. So we were a couple of units short last year of our delivery forecast, it was 120 versus 123. You may have heard Phebe on our fourth quarter conference call referenced the fact that 2 of those were strictly customer combination, so that has nothing to do with manufacturing line, has nothing to do with supply chain. There was one that was on us, so we'll own that.

And when I look out at this year, had talked about, I think, notionally 148 aircraft. That's a very specific, laser-focused number. We refined that to 145. And rather than sort of look in the mirror and be self-critical about that, what do I think about in terms of those numbers and the multiyear outlooks we gave? The intent there was to give multiple indicative data points, whether it's delivery units, year-over-year revenue growth, margin expansion rates, that would help the market triangulate sort of the earnings trajectory that we are on. When I look back at what those implied earnings were in '23 and '24 when we made those forecasts at this time last year, we're spot on with where that is. There's a little puts and takes here and there, but between mix and number and other factors in the business, we're spot on with that earnings forecast. And to your point, the 2024 forecast remains intact, so we feel good about that. Whatever the final number is, it will be closer to that original delivery forecast.

Last point I'll make on this is because you mentioned the 700. Obviously, the timing of that certification and entry into service is important to us. As you think about this year, we've said that we expect the certification in the summer of 2023 with deliveries to follow in the back half of the year. And I think it's important for people to understand that while Gulfstream and The Aerospace Group traditionally has a sequential sort of seasonal ramp in the first quarter for the fourth quarter, I would expect that to be exacerbated this year with a more modest first quarter and a steeper climb to the fourth quarter, all predicated on that G700 entry to service.

David Strauss

Okay. Touching on the margin trajectory you've talked about. So 13% to 16% by 2024, low 20% kind of incrementals. Why aren't they better than that? I mean, I'm going to keep coming back to this question, but why aren't they better with 700, lower aftermarket mix, lower R&D? It seems like -- Yes. It just seems like a low bar. I know it's....

Jason Aiken

As we've talked about before, it's easy to say and then very hard to do. But look, to your point, the G700 will be a tailwind to this margin trajectory. As we've said, those airplanes will enter service with accretive margins out of the gate. That is fundamentally different than the 500 and 600, we've talked sort of about the reasons why those came in at lower margin but then had performed nicely since.

So the 700 is supportive of that margin trajectory, and to your point, you would think all of the things equal, why not maybe a little bit more? To be clear, while they'll come in accretive margins, that won't be a peak margin. There will still come down the natural learning curve, and we expect to see that margin improve over time. And likewise, the 800, when it comes into service, will come in at accretive margins but we expect to see that come down a learning curve and grow over time.

So what's offsetting that? I think there's a couple of things. Number one, you mentioned R&D. We actually will still have a bit of an elevated R&D this year. It's actually modestly higher than last year, so that's a little bit of an offset. And then likewise, there's some underlying mix shift within the business to include, in terms of the delivery profile, to include a bit fewer G650s and some incrementally more G280. So that naturally has a little bit of a margin impact in that delivery mix shift.

So net-net, we're -- we feel good about the margin trajectory that we've laid out there. To your point, is there opportunity for upside? Keep challenging the Gulfstream guys to do it. I think more important than whether the '23 and '24 margin guides have opportunity is that we don't see that being the end. With the 700 coming down a learning curve, the 800 coming down learning curve, we see margin growth trajectory beyond 2024 and that's what the expectation will have.

David Strauss

Moving over to Marine. So I guess the most surprising aspect of the guidance that you gave in Q4 was guidance for flat -- forecast for flat Marine. So you've obviously had a ton of growth in the business that was highlighted on the call as well. What underlies that flat forecast for this year?

Jason Aiken

Yes. I think the most important point I'd make here is that the long-term growth trajectory that we've been on that Phebe has described, just call it sort of $500 million a year of year-on-year growth in that business with potentially some lumpiness in any given year, but averaging $400 million to $500 million a year. That remains intact. We've actually been higher than that for the past 5 or so years. We expect to be at the high end of that in the next couple of years. So this is sort of a 1-year lumpiness that was implied in Phebe's longer-term expectations, maybe a little bit more lumpiness than people expected.

But why is that? Really, what we're seeing here is a manifestation of COVID's impact on the supply chain sort of catching up with us in the shipyard. And when you think about it, everything that takes place in a shipyard, both an issue that adversely impacts the shipyard and the efforts that you undertake to overcome that issue, they take a lot of time to work their way through the system. So we're talking about really manifesting in 2023 the impact that COVID had which started in 2020 on the supply chain and the workforce, and really exacerbating a generational changing of the guard when it comes to the workforce in terms of attrition of older shipbuilders and onset of new shipbuilders and those impacts. That's now catching up with the supply chain, and we got to get back on our cadence, get the throughput flowing, and that will get us back on a trajectory to grow.

But that's just -- again, it's a shipyard environment, and it takes time to make that happen. But again, if you look back to when we made that outlook of -- multiyear outlook of $400 million to $500 million a year and where we'll be a couple of years from now, I did some rough math, I hope it will be about, call it, $500 million, $600 million cumulative. Better than revenue growth in our original forecast we've implied. I know that doesn't sway people in terms of this year, but I'm looking at the long term for this business, and so I still feel good about where we're going.

David Strauss

And 2 key programs in Marine, Virginia Class and Columbia? Maybe touch on how things are progressing on each of those?

Jason Aiken

Yes. Virginia, I think, was the hardest hit by this COVID supply chain issue. We were, as a team, on a path and had a strategy, and we're actually approaching the 2 per year cadence that we were trying to get to between us and our customers on Virginia Class. COVID has sort of knocked us back a little bit from that. But I would tell you that between our team at Electric Boat, our partner and our Navy customer, everybody is aligned in terms of the prioritization and in terms of getting resources that are needed on this program to get it back, hitting its stride on its cadence. So it's kind of like everything else in the shipyard, it's a gradual thing that's going to take a little time. It's not going to turn a light switch on to be back on track, but it is trending back in the right direction because of that alignment of those 3 parties and the commitment they have to getting on track.

I think when you look at Columbia, things remain encouraging there. We're about 30% complete on the first boat build. And while it's tough to get on a program of that magnitude sort of externally observable milestones or data points on how we're progressing, I think the way to think about that is all the conditions for a successful construction are there in terms of what we've talked about. A very mature design before we started construction, the most mature design we'd ever had in submarine construction before starting first boat construction. The facility structure has been put in place. That's almost complete now, so that's there to support the program. And I think from the Navy standpoint, they've appropriately prioritized Columbia. It's their top priority, and so it is absolutely going to get the resources that it needs to stay on track.

And so as we sit here today, we remain on track with the program schedule. Our daily focus is on bringing margin out of that schedule to continue to give ourselves the opportunity to meet and beat that delivery requirement. But the net result of all of that that I just said in the Virginia and Columbia is on is that program will really represent the lion's share of the growth in the group over the next several years.

David Strauss

And the margin trajectory, margin range at Marine, I think you're at the lower end of kind of that 8% to 9% range right now. Is that Virginia Class? Is the Columbia mix ramping up? And it's 9% plus that you've talked about in the past, is that still realistic and is that 5 years out or is that nearer term?

Jason Aiken

If I had to give you a one-word answer, I'd say, yes, it's realistic. Yes, it's realistic. That target is still realistic. We're really right now coming through 2 major factors, and you sort of alluded to them. One is getting Virginia back on track. And again, predictability of the timing of that is something that I'll stay away from, but I'm convinced that we're on the right path there.

And then the second is a bit of mix issue, so where do we have to go to get back on that track to getting into the 9% plus and approaching 10% range? You got to get Virginia back in its stride. You got to get to Columbia, second construction contracts, fixed price work. That gives you an opportunity there. That's a little further out, but that's kind of taking these in sequence.

And then we really can't forget even though we tend to talk for obvious reasons in terms of orders of magnitude, we tend to talk about submarines. I don't want to forget other 2 shipyards, Bath Iron Works and NASSCO. And NASSCO has been performing very well, solid margin business, but they're continuing to learn and continuing to improve out there, so I think we've got more opportunity from them. And of course, Bath is coming through the transition that they've had on the stop and the restart of the DDG-51 line and some of the issues they've had there. So they're on a trajectory where they've got opportunity to improve and continue to contribute to the group. So I think you put those 3 together, and we've got a path to get there. I'd probably be out ahead of my skis if I try to predict the timing, but we do absolutely believe that we will get there.

David Strauss

Moving over to Combat, so you went through this period where you kind of sort of -- you were burning down. You had this huge backlog at Combat, you started burning it down. You've got backlog growing even now [indiscernible] very well in the budget. You've got Poland that's coming through. Why isn't that? Why don't we see all this kind of come through to Combat? I guess it's a shorter-cycle business, why don't we see some of that start to come through maybe a little bit earlier than your forecasting?

Jason Aiken

It's interesting you call it a shorter cycle business. It's definitely as short as in ship though, but it's not as short as the Technologies portfolio. So I would think to your point, our portfolio in Combat Systems is in high demand when you look across the spectrum, both U.S. domestically and internationally. And of course, that is probably not a surprise given the changing threat environment around the world. And so I think to your point, everything is supportive of an inflection point and the change in the trajectory. When you look back a couple of years ago, we had expected to be down low single digits in '22 and '23. We've actually managed to stay consistent since '21, so there's implied improvement already in the performance. And now, we're talking about a return to growth in '24 and beyond.

So I think a couple of key factors there, to your point about short cycle and when this has happened, the shorter-cycle piece of our Combat business would be the munition side of the business. And we're absolutely seeing demand signals for obvious reasons on that, starting to see some contract activity being left there. But the biggest issue there is capacity, and we are working in a coordinated, strategic way with our Army customer to first get the capacity in place to then ramp up production.

So that just takes some time, and I can't really get out ahead of that and overcommit on that in terms of what we're doing, but that is a coordinated effort. And so there is absolutely growth implied in that, but it's not like we can just put in another shift on the munition side and all of a sudden, we ramp up activity. We actually have to create additional capacity [indiscernible] so that's why that's a little longer term than you would normally expect in that cycle business.

And then the other real big piece is in our European Land Systems business. There's tremendous order interest across the board in their markets, in their home markets and beyond. You started to hear rhetoric that not only are countries committing to the 2% of GDP commitment for defense spending, they're saying -- many are saying that's now a floor. So that continues, I think, to underpin the demand environment there. But as we've seen in the past, I think it would be a little bit of a [indiscernible] for me to try and predict how and when that comes in, so we can turn that on. We have not had a capacity issue; we can earn that on as demand manifests itself in contracts and order flow. But again, that's a little bit less predictable.

So I think to your point, there's probably upside bias in this business, but timing-wise, we'll have to see how it plays out. But we're talking about low single-digit growth in '24 and inflecting to mid-single digit at some point shortly thereafter.

David Strauss

So to get to the corporate level, I want to ask about cash flow. You convert above 100% last year. You're guiding to above 100% this year, it implies a couple of hundred million in free cash flow this year. Can you readjust to that kind of the moving pieces and even the outlook beyond, specifically touching on the unreceived -- unbilled receivables to large international customers, where those stand, what the runoff is expected to look like, how important that is to the overall free cash flow outlook?

Jason Aiken

So there's a lot to unpack, so let me try and take it one at a time.

David Strauss

We're on the clock.

Jason Aiken

One step at the time, I'll try and do this quickly. So you asked about the bridge, a couple of hundred million improvement in free cash flow year-over-year. The way I look at that is sort of headwinds and tailwinds. Though the tailwinds that are giving us improvement. You can talk about, number one, just the bottom line, improved net income, right, I assuming converted into cash. Accelerating that is we've talked about a pretty meaningful decrease in non-cash income, some of those below-the-line items. So the implicit cash net income is better. Lower CapEx, albeit still elevated at Marine Systems as we ramp up some of those investments, we'll start to see a step down in CapEx this year. And somewhat lower cash taxes, obviously, we didn't get the R&D fix we were hoping for last year so that in this last year, that amortizes, it starts to step down a little bit over time.

So those, I would say, roughly speaking, aggregate to about probably a $600-ish million tailwind to free cash flow year-over-year. But looking the other way, we've talked about an increased pension contribution, and second major piece would be OWC. While we expect to continue to see OWC come down this year, it will not come down as much as it did last year. And so you combine those 2, and let's call it a roughly $400-ish million headwind. So the net of those factors, to your point, I think your math is reasonably in the ballpark is a roughly $200 million year-over-year improvement.

So that's '23. When you look out into the future, I think this business should, year-on-year, barring in the moment issues around intensive capital investment or OWC issues. It should be a 1:1, 100% conversion of net income to cash business. And so we've obviously seen and thoroughly vetted some of those things that became headwinds over the past few years, between the unbilled receivables and some of the ramped-up capital expenditures. We're starting to see those shift into tailwinds, right? So we've seen the large international out program has been unwinding, the payments continue as scheduled for that contract restructure from several years ago. So we'll see that pretty much come through its paces by the end of this year, as we talked about.

The next phase of that would be the Ajax program in the U.K. We're working with that customer, very supportive of the program. It's coming through its test regimen, and we believe based on the progress we've made with that vehicle that we'll start to some payments resume here before the end of this quarter, and then it will continue to unwind out of the future over some period of time.

And then the last thing would be as the CapEx comes down, that depreciation starts to move into the programs and it get reimbursed for that. So that ought to shift to a headwind to a tailwind. So all of those factors are what give us good reason to see at or above 100% conversion even out beyond '23.

David Strauss

Okay. Capital deployment, so as is custom for you, you didn't assume anything in your guidance. You have some near-term maturities, pretty low rate. It sounds like you're going to take those out, but how are you thinking about the context of having more maturities beyond this year, I think, in '25, you've now these as well. How are you thinking about reigning in, taking down the leverage where you're in a pretty good spot today versus share repo, how are you weighing that allocation?

Jason Aiken

Yes. I think our -- first off, at a high level, I won't repeat the moment. Our capital deployment priority hasn't changed, right? Talk about the share repurchase, et cetera. And we intend to take a shareholder-friendly approach to capital deployment.

As it relates to the trade-off with debt maturities, we've talked about the fact that coming into this year, having come from a high back in 2018 and working some of that debt down, we're now in an opportunistic place where we can decide based on what the other capital deployment opportunities are, whether it's compelling share repurchase, a bolt-on M&A or what it happens to be, as to whether we roll some of that debt or just take it down. But that will be an in the moment decision. And based on what the other capital deployment priorities are, I think the key takeaway is that we have sufficiently strong free cash flow that we can if we decide to pay down that debt. It's pretty low rate than at this point, so we'll be replacing it with rates that are roughly double what it's at today. So we have to think about that. But more than enough free cash flow to repay that debt, pay the dividend and have enough left for other tactical opportunities. So see the portfolio is wide open.

David Strauss

Okay. Can we pull up the audience response question? Okay. If you could currently own the stock, if you -- we would appreciate the participation, get the key pads in front of you.

[Technical Difficulty] Next question, please? General bias. [Technical Difficulty] Next question, please. Through cycle EPS growth. Next question, please. And our last question, please? Insightful.[Technical Difficulty]

Jason Aiken

There's the answer. That answers your last question.

David Strauss

Sure, you'll take it as a [indiscernible]. Next question, please. [Technical Difficulty] What multiple -- similar range as to where you are today.

And I think there's one more, one more question -- no, there's two. Significant share price headwind. [Technical Difficulty] Okay. And I think this ESG question, the last 1. [Technical Difficulty] Do you consider ESG, one investing and looking at GD [Technical Difficulty]

All right. Thanks, everyone. Thanks, Jason. Appreciate it.

Jason Aiken

All right. Appreciate it, David. Appreciate it. Thank you.