General Dynamics Corporation (NYSE:GD) 44th Annual Aerospace/Defense & Industrials Conference February 15, 2023 10:00 AM ET

Company Participants

Cai von Rumohr - Cowen & Co

Conference Call Participants

Phebe Novakovic - Chairman and Chief Executive Officer

Cai von Rumohr

[Starts Abruptly] 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 has talked about it for a while. But obviously, its relevance is increasing as a result of the 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?

Question-and-Answer Session

A - Phebe Novakovic

So -- can everybody hear me? Howard is reminding me that administrative by the [indiscernible], I have to state there's 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, ammunitions 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 the mid to low in the out years.

Cai Von Rumohr

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

Phebe Novakovic

Yes, 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.

Cai Von Rumohr

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?

Phebe Novakovic

Well, we certainly hear from our customers that they're interested, but it takes a while from 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 Mato, 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.

Cai Von Rumohr

And then the weapons area is around 25%, 30% of combat. It usually does not get much attention.

Phebe Novakovic

Not allowed, yes.

Cai Von Rumohr

It's been flat since 2019. Can you give us any sense as to where it might go over the next couple of years?

Phebe Novakovic

So I don't want to speculate, but let me tell you what we do know. We have had interest [Technical Difficulty] 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.

Cai Von Rumohr

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.

Phebe Novakovic

So the -- that line of business, not just for us, but with that funding line of business within the defense budget has been relatively flat to declining for some time. And there was a good [Technical Difficulty] for that. And that is as the Army was upgrading and changing and modernizing several lines of munition, that founding 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.

Cai Von Rumohr

Got it

Phebe Novakovic

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.

Cai Von Rumohr

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

Phebe Novakovic

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.

Cai Von Rumohr

Got it. So...

Phebe Novakovic

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

Cai Von Rumohr

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 on Ajax were essentially resolved. And I think you've talked about the payments have resumed there. When should we assume basically the unbilled gets worked down on that program?

Phebe Novakovic

So I think what I have said is that we anticipate given the maturity of the vehicle and where it is in 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.

Cai Von Rumohr

Got it. So you mentioned on the fourth quarter call that Marine, particularly EV 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?

Phebe Novakovic

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.

Cai Von Rumohr

Got it. Okay. And should we think that the trend there in -- because the retirement is that continuing at that rate of the experience as [Multiple Speakers]

Phebe Novakovic

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

Cai Von Rumohr

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

Phebe Novakovic

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.

Cai Von Rumohr

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 three years, an MS margins ever get back to where they were in 2021?

Phebe Novakovic

So Mission Systems was impacted by a shortage in several of their key parts and we believe, like where they stand right now in terms of recovering halfway through this year, but it remains a watch item as you would expect with any very complex problem. But what gives us instead of a little bit of confidence in where they -- how they're 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 simply will not be available within reasonable lead times. So kind of like where they are right now.

Cai Von Rumohr

So if we look at this business…

Phebe Novakovic

And by the way, but if we go back to your fundamental -- the predicate of your question this is the product business has always been a strong margin performer.

Cai von Rumohr

Right.

Phebe Novakovic

So we expect that their margins will again improve once we get through this supply chain channel.

Cai Von Rumohr

It sounds like, because if we look at it, I mean, we're going through two years where it kind of would struggle a little bit more. It kind of sounds like now we're kind of at a bottoming and then hopefully things will solve on its own.

Phebe Novakovic

We should 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.

Cai Von Rumohr

Right. So new account unlike others, new 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?

Phebe Novakovic

So GDIT has increased its margins every year for the last four years, except during pandemic and where they held their own in terms of the 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 the margin performance.

Cai Von Rumohr

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 the beginning of a trend? Are there more things initiatives you'd like to fill in that sector?

Phebe Novakovic

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

Cai Von Rumohr

Because I remember, Jason, I think made the comment that you know 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 that, maybe you might need to do something else in that sector?

Phebe Novakovic

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 from the market to get into M&A.

Cai Von Rumohr

Okay. Okay, no surprise.

Phebe Novakovic

What a shock.

Cai Von Rumohr

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 under the radar than you thought earlier in ‘22. So is there been any change in terms of the R&D profile and maybe the cost of bringing the G700, G800 to market?

Phebe Novakovic

So R&D will abate a bit post the certification of the G700 and G800, 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 airplane. So we may -- we'll see a slight reduction in R&D, but nothing significant.

Cai Von Rumohr

Very slightly after the G700 and G800. What kind of incremental margin should we be looking for their -- I believe, there were 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 incorrectly or there additional…

Phebe Novakovic

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.

Cai Von Rumohr

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?

Phebe Novakovic

So you're a brilliant analyst, but I'm going to pick it with you, kind of, 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 three airplanes slipped from last year into this year, two were because of customer preference and one was because we were not ready, not supply chain. So -- and all three have already delivered. They delivered last month. So it is a challenge managing this supply chain, but Gulfstream has done very well.

Cai Von Rumohr

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?

Phebe Novakovic

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.

Cai Von Rumohr

Okay. And so one of the big questions really that people ask about Gulfstream biz jets 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?

Phebe Novakovic

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't 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 worry there a macroeconomic perturbation. The next few years are solid for us.

Cai Von Rumohr

Got it. So one 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 biz jet 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 about…

Phebe Novakovic

So I think it's an assumption and not necessarily approvable 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 base 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.

Cai Von Rumohr

Got it. So you've talked about cash flow conversion. This year, 105% of Ajax payments resume and Gulfstream book bill holes at one. Do you think those two assumptions or you're at all concerned about those assumptions?

Phebe Novakovic

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.

Cai Von Rumohr

Got it.

Phebe Novakovic

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.

Cai Von Rumohr

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 Ajax 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%?

Phebe Novakovic

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. All that matters at the end of [Technical Difficulty]

Cai Von Rumohr

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

Phebe Novakovic

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

Cai Von Rumohr

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?

Phebe Novakovic

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 four 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.

Cai Von Rumohr

Got it. Would you -- I mean, Nick once, your predecessor, while at 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?

Phebe Novakovic

So we 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 uniform. 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.

Cai Von Rumohr

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

Phebe Novakovic

Well, let's -- you 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.

Cai Von Rumohr

When you say opportunistic, you 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...

Phebe Novakovic

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

Cai Von Rumohr

Okay.

Phebe Novakovic

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, that is necessarily that ensures the best possible return.

Cai Von Rumohr

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?

Phebe Novakovic

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 things that sometimes hits 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 response 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 at 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.

Cai Von Rumohr

Now you mentioned that. And last night, we had a dinner with a couple of the Mckinsey [Indiscernible] 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-bill. 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?

Phebe Novakovic

So the federal government and the defense department was not immune, suffered the same kind of labor market perturbation at 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.

Cai Von Rumohr

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

Phebe Novakovic

So look, you know, 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 that 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 fundamental 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.

Cai Von Rumohr

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

Phebe Novakovic

So I think over the past few years, we have invested, 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.

Cai Von Rumohr

Terrific. Thank you very much.

Phebe Novakovic

Good to be here.