General Dynamics Corporation (NYSE:GD) TD Cowen 45th Annual Aerospace & Defense Conference February 13, 2024 11:30 AM ET

Company Participants

Phebe Novakovic - CEO

Conference Call Participants

Cai von Rumohr - TD Cowen

Cai von Rumohr

Okay. If everyone's here, take your seat. We're going to move on. We're delighted to have with us our next company is General Dynamics and delighted to have a Chairperson and CEO, Phebe Novakovic. This will be an interview. So there will be forward looking statements made or remarks made. And so think about Reg FD. You'll be aware of that. So maybe to start, Phebe, maybe you could kind of recap the key takeaways from 2023. I mean, it was a really good year, but things went a little bit differently than you thought when you started.

Phebe Novakovic

Well, different in a good way is always beneficial. I think the two things that sort of surprised us was the timing and the strength of defense revenue and the lack of a G700 certification. That said, we accomplished a lot last year and particularly in setting us up for additional revenue growth. And in that revenue growth, driving margin improvement that will bring with it additional earnings, which is always, you know, a very strong thing. Operating leverage is critical.

Question-and-Answer Session

Q - Cai von Rumohr

Great. So on the call you mentioned the temporary disruption from the Hamas attack out on Gulfstream orders in the fourth quarter, but maybe update us, you know, more broadly, what does that mean for Israel's ability to develop 280s and given the disruptions of their workforce and like, what does that mean for 280 deliveries potentially for this year?

Phebe Novakovic

So we fully factored in their projections on the 280. They are doing a good job replacing those who were called up to military service with retirees and management. We have factored all of that into our plan. I would say they're doing a bit better on their production and testing plan than we had anticipated, but we like where we are right now and with them in terms of how we have de-risked that profile.

Cai von Rumohr

So one of the questions we're asking everyone here is, supply chain. It's been a big disruption the last couple of years. As you look at it today, is it about the same, getting better? How would you describe it?

Phebe Novakovic

Well, let's break it into the two groups where supply chain has had the most profound impact. First in aerospace, aerospace supply chain is getting better. You saw that in our fourth quarter deliveries, we delivered 39 airplanes in the fourth quarter of last year, compared to ‘24 to ‘25 in the previous quarters. That was permitted by improvements in the supply chain. That said, there are still elements of the supply chain that are struggling, that manifests itself and in while last, still significant out of station work. The ramp up this year will begin to tax them. But we think we've given you a very balanced plan, understanding our supply chain very, very well and what the potential impacts could be.

On the marine group side, I think a little context here is important. When COVID impacted heavy industry and labor-intensive industries in a profound sort of way and twofold. One was a larger, cohort of retirees of experience labor and workers. They left at a higher degree and a higher number than we had anticipated. And then the very well-known COVID -- post COVID labor disruptions, both of those things impacted manufacturing businesses across the United States, but particularly those who are labor intensive.

That said, our Navy customer has been very, very good at working with us and understanding the supply chain, perturbations and some of the challenges. And they've been pushing through long lead material through us in order to stabilize that supply chain. It is getting better, but there's still elements of it that have a long way to go in terms of improving their productivity.

Cai von Rumohr

And then the other quest sort of issue is labor, maybe speaking to both Gulfstream and to Marine? Are -- is the labor market easier today? It's easier to higher folks and what's your attrition rate look like?

Phebe Novakovic

At Gulfstream we do not have a labor issue. We have a number of young, highly trained in place workers. We do not have an attrition problem. In the Marine group, our hiring has improved. And one of the things we're very pleased to see is we have a very robust training program and the new ship builders who are coming through that training program are coming out at higher productivity levels than we had seen before. They will continue to improve their productivity over time as they come down their learning curve. So for us, in order to offset a lot of the impacts or some of the impacts on, particularly in the marine group, on the labor market that have had on our supply chain, our job is to increase productivity and velocity so we can help offset some of those impacts. And we're doing just that.

Just to give you an example, what being our throughput on Columbia increased 30% last year. We're seeing nice velocity, we're seeing nice productivity, but we've got -- there's always more work to do here. Always.

Cai von Rumohr

Got it. So I think you'd mentioned, that demand was strong in the fourth quarter. What are you seeing here in the first quarter and I guess you have the Hamas disruption in the fourth quarter. I mean, a little hard on the outside to see what that actually meant.

Phebe Novakovic

On demand?

Cai von Rumohr

Yes.

So as we enter this year, the pipeline remains strong and we've got nice solid pace of orders. And I would say the United States particularly strong. This is a Gulfstream.

Cai von Rumohr

Your guide calls for, and this sort of confused me, 39% increase in sales, but a 44% lift in deliveries. And presumably the mix is shifting toward the G700, which is three times expensive as the G 280, which might be a little bit less. I would've thought, you might have more in terms of per unit, the revenues would be stronger.

Phebe Novakovic

I thought 39% was pretty impressive growth.

Cai von Rumohr

It is, but it on 44% deliveries better.

Phebe Novakovic

Look, aerospace is more than just airplane deliveries. We have a large, about $3 billion service business that includes government work that tends to be very lumpy. And that just drives a lot of the revenue that we're looking at this year, but we're quite comfortable with the plan we gave you is quite balanced.

Cai von Rumohr

But should we assume that, I mean, so is the service, so Jet is not going to be down this, I'm still confused.

Phebe Novakovic

Well, look, service varies and jet service continues strong Gulfstream service continues strong particularly with the increase in the embedded fleet, but our government orders and that is both at Gulfstream and a little less at jet are quite lumpy. And so this year, we see less of that coming through, but managing that 39% increases is challenging. We're quite comfortable that we can do it. We've got all the tools in place to do that, but we've fully factored in all of the elements of these very complex and large businesses in our revenue production. So don't get out ahead of us here.

Cai von Rumohr

What are the key margin drivers for Gulfstream this year? I mean, where is R&D flat? I mean, because the revenues are up so much, or is R&D to sales down? What about out of sequence work? Is that an issue? G 280 disruptions? What are the things that are moving those margins?

Phebe Novakovic

So we see margin improvement at Gulfstream, and we'll see over time increased margin improvement. This year it's all about volume mix, cost efficiency. Recall also that the first two, lots of 700 carry with them the full cost of the developmental program. Those deliver this year, R&D will remain essentially flat. We've got to finish up the 700 certification. We have two more airplanes in the certification mix. R&D will come down as a percentage of sales obviously.

Cai von Rumohr

So if we turn to Marine, EBs material delays, supplier quality problems, they continuing in the first quarter or is it easing up a little bit?

Phebe Novakovic

In some places, some places are getting better and others are continuing to struggle. And as I said earlier, our key challenge then is to increase our profitability and our throughput, that allows Navy to get it ships a little bit faster. And again, to offset some of these cost impacts of delays in supplier and supplier deliveries. And I would say too, as we do in Gulfstream, we have a number of flyaway teams that are embedded in with our suppliers, and that helps over time. And the Navy has been an important partner in recognizing these challenges and addressing them quite aggressively. And I think those two things, Electric Boat’s focus on its supply chain and its own productivity. And, and the Navy's, I think long lead material and ability to see into the future is really helped. It's a good partnership.

Cai von Rumohr

So I think on the third quarter call, Jason noted, you know, labor force stability and one of the things we went last August, we visited Huntington and they were talking about, you know, gee, the gap between working at Home Depot and working at the shipyard has narrowed. And you know, you guys had had some labor contracts. Is your attrition rate improving?

Phebe Novakovic

So at Electric Boat and frankly throughout the Marine Group, we have seen increased hiring. Increased training, putting new workers and new ship builders through that training program has gone very, very well. A lot of the labor shortages that we have seen have largely abated. It's simply getting these new workers in fully trained and then getting them down their learning curves as they enter into the shipyard. But we're pretty encouraged about what we see right now. There's a lot less attrition now than there was shortly after Covid. Electric Boat went into covid in pretty strong condition. And if you enter a crisis with strong operating performance, you tend to weather the crisis better. So we came out of it stronger than most of the supply chain, but we were not without our challenges. And that has showed up in, particularly our margins. So you can imagine we're going to be laser focused on margins.

Cai von Rumohr

Right. So marine revenues kind of really overperformed by a big margin last year. How come they were so much above your initial guide and what's the chance it could happen again?

Phebe Novakovic

Columbia came in faster, there was some additional destroyer work and repair came in at a faster level than we had anticipated. Again, reflecting the Navy's needs they've increased and I think quite publicly been open about their need to get the ships turned quickly, so that velocity of contract activity increased and that resulted in increased revenue for us. Revenue that was coming. It just came a little bit earlier.

Cai von Rumohr

So if we think about margins, you mentioned that's a focus, I mean, everyone is worried about fixed price development that the Air Force programs have in Northrop, Boeing, you name them. But I mean, my recollection over time is that shipyards are different because you don't want, you can't just do a development Columbia, you got to basically have a contract that's a little more forgiving. I mean, it might be fixed, well, Columbia, the first two are I think cost plus, but as you move into production, it's a fixed price incentive with a ceiling and with a share pattern. So how should we think about the risk and the margins and the uptrend? It seems like if you perform.

Phebe Novakovic

So within our plan horizon, it's all about increasing our throughput and our velocity, increasing our ship builder productivity and managing costs. And as I said, we're going to be laser focused on managing costs. So in, during our plan horizon, we're quite comfortable that we can drive margin improvement, assuming there is no additional deterioration in the supply chain. But as I've said earlier, we put together a plan that we see as very balanced, including in the Marine group. When you get to bill, when you get into the future to bid a fixed price on particularly submarines where these are large, long term contracts, you've got to truly understand your cost environment. The Navy understands that thoroughly and we will negotiate with them appropriately as we always do. They understand our challenges, we understand their needs, that intimacy is important. I think discipline on all parties is critical.

Cai von Rumohr

Is there a reason…

Phebe Novakovic

By the way, we are the company that suffered, if you go back 25, 20 or maybe even closer to 30 years, remember [A12] for those of you who've been around for a while, fixed price, development contract and almost took out the old GD and McDonald Douglas spent 20 years in the U.S. court system, including I think two, if not three times through the Supreme Court. So for many, many years, fixed price development contracts were taboo because it can -- they can damage the industrial base badly, and the customer ends up not getting a product. A12 was never delivered. I mean, this is ancient history, but my experience in life is the fundamentals don't really change. You make money the old fashioned way. Contracting and programming for the realities of contracting and programming for large defense programs doesn't change. So remembering what the basics are on the fundamentals of really driving the industrial base.

Cai von Rumohr

But A12 was a plane. I mean, basically with ships there is a more forgiving -- it's a fixed price, but fixed price within…

Phebe Novakovic

Well, forgiving isn't the right word, because that would suggest the Navy's forgiving and the Navy's pretty tough. I think there has been an understanding of the economic realities by the Navy of what is face, what the shipyards face, and frankly much of their industrial base spaces. I think that kind of realism is important.

Cai von Rumohr

Combat, my favorite up 13% last year. You thought it was going to be flat. So what's given likely continue doesn't sound like OTS is going to slow down and European land systems looking pretty good. You only have a 3% increase this year.

Phebe Novakovic

Well, once again, 3% on 13% I think is pretty impressive. So this year's a lot about absorbing the growth that we experienced last year. As we have continue to increase the production and throughput on munitions that will continue to build over time, we've got that fully factored into our plan and there's remains strong demand across Europe and in the United States. It's just really a question of timing in a high growth environment, oftentimes and particularly a growth environment that we are seeing in land systems, you tend to have lumpy orders, contracts just executed different timing levels.

Cai von Rumohr

I think what didn't the army just say they want a double 155 output by October?

Phebe Novakovic

We have fully factored in all those plans, into our plan. Think about 155 production in this way along with our army, customer and partner. We have more than tripled the 155 production in two plus years. That tells you what industry aligned with the customer can do when you are fully focused on doing the right thing. And it's important, you need to replace our stockpiles.

Cai von Rumohr

That's an issue. One of the issues is like sort of how far into the future, but it certainly looks like munitions replenishment is going to take a while. European vehicle demand looks like it's quite durable. You make the point it takes a while till folks come around to order. The orders are lumpy. What's the potential for combat that sort of the uptrend continues through ‘26?

Phebe Novakovic

So as we see mid to upper single digit growth throughout our plan period. And that's driven by munitions, both increased increase in our portfolio and in our activities as well as just increase in the actual production of the shells. Bridges are the demand for bridges is increasing. There are a lot of rivers in Europe, and I would also say in we're seeing some in Asia wheeled and track vehicle demand is increasing and demand in the United States at land systems for both tracked and wheeled vehicles. It's also increasing, but the domestic and foreign. So we see the threat environment is unfortunately as you all know an ugly -- we're in an ugly period right now and that is driving the need for our allies and the United States to arm in the face of threat.

Cai von Rumohr

We haven't talked for a while about the Saudi lab or the -- or Ajax. Are they doing okay? Are they sunset started sunset?

Phebe Novakovic

So, as you know, we talk about one of these programs as a large international order through Canada, that is gone extremely well. As for those of you who may remember, we had a lot of cash tied up on the balance sheet for a while that has completely been liquidated. And the vehicle is a superb vehicle and we're coming down toward the end of that program. Ajax is stabilized it's in test and is performing very well in tests. The British soldier likes it and we'll continue to work that program, but the risk of from on the cash perspective has been taken off that program as well.

Cai von Rumohr

So if we turn to technology, I think, Jason mentioned 13.5 billion in awards last year versus 8 billion in revenues, 15 billion of pending awards, 2 billion under protest. How come only low single digit growth?

Phebe Novakovic

So a lot of these orders come in the form of IDIQs that enter revenue over time. So our backlog will support the revenue growth going forward in additional to new orders that will manifest. We project, we single digit growth for this business, but given the size of this business and additional order activity and margin improvement, we see some really nice potential for solid earnings growth.

Cai von Rumohr

So you mentioned margin potential, but basically unlike others, you don't show us adjusted EBITDA, you just show us the EBIT after the amortization, and if we look at it on an EBITDA basis of the margins also going up or is this just that you're winding off the amortization?

Phebe Novakovic

Somewhat, but remember mission systems is in the middle of that. And has very little amortization. So as they've come for them, it's coming off of their legacy programs, which has impacted their revenue. And then, and earnings and margin obviously, and then coming back up slower to ramp new programs. But both of those businesses have been investing in vast currents. Take mission systems, for example, high-end crypto space, undersea, guided munitions. All of those are areas where they are targeting their R&D investments. And a number of those are beginning to pay off just as a kind of a indicator of how they're doing. We expect a 25% increase in their space order activity this year. So these investments have been well placed.

Cai von Rumohr

So I was going to get to that. So I think, what they tripled the bid submits in 2023, but you've got revenues down slightly, but what should we look for mission systems? What should we look for the bookings? I mean, is the book to bill going to be?

Phebe Novakovic

I think they'll have a very solid book to bill. I would say in the one to one, maybe a little higher. But I like their positioning. They are a heavy merchant supplier to a lot of the primes, and that's a good place to be, particularly as you see growth in platform businesses, they will grow along with those platform businesses. So they're in a good position. And again, throughout our business, you'll hear me say this again and again and again. It's execution, execution focus on your margins, you know, in a growth environment and this should be obvious, but I will just reiterate it anyway. In a growth environment, cost is often difficult to control overhead in particular. So that is why we are laser focused on our cost and our margin improvement. That's actually how we can drive value for our customers, for our people, for our shareholders, increase those earnings that go to naturally increase over the period as our revenue grows. It's all about operating performance.

Cai von Rumohr

So you mentioned space orders up 25%. What are the key, any particular is that, I assume a big portion of mission systems?

Phebe Novakovic

It's some, it's not that big, right. They're very active in under sea and that as everyone knows it's growing,

Cai von Rumohr

But so the revenues are down a little bit this year. But should we think that as we move toward ‘25, ‘26, we're talking mid-single digit, maybe a little?

Phebe Novakovic

Looking to load on occasion mid-single digit growth. Again, this is a very large portfolio. And the key will be, you know, this is a broken record here, but I think it's important you understand the key is just driving operating performance, get those margins up, that's controlling your cost in this growth environment.

Cai von Rumohr

Right. Right. And so what about the margins at technology? I mean, based emission systems has been below, you've been kind of below where you once were. When do you see that?

Phebe Novakovic

Their natural margins are higher and they will work toward that. You may recall they got hit pretty hard by supply chain shortages, particularly in chips, but not exclusively in chips. That is behind us now. And as they ramp up on these newer programs, you start off with lower margins, but they'll continue to do better and better. This is a high operating leveraged company.

Cai von Rumohr

Got it. So we've talked about, I guess all of the areas, but I guess we haven't talked about the G700 that sort of is still waiting for certification. I think you have 15 or you had 15 that were ready to go. Should, I mean, what can you tell us about the certification?

Phebe Novakovic

Well, we're largely done. And we're simply waiting for the FAA to conclude its deliberation, so we're on track. It's just -- that is as we've been quite open, not a process that we control. But we're on a good track here.

Cai von Rumohr

I guess, on the fourth quarter call you were talking about Gulfstream certainly being better 25, 26, Marine 600 million to a billion starting in ‘25 for a couple of years. Technology is now sounding like it's going to do some pretty good things. Combat looks like it's well positioned through ‘26. I mean, on paper it looks like all the major operations are kind of have an upward bias through ‘26. Any major headwinds that we should think about that could disrupt that kind of a run?

Phebe Novakovic

Nothing other than the ordinary, unexpected geopolitical events and macroeconomic stress. Those are always the two factors that impact us. But if you think about it, and for those of you who followed us for many years, we have been investing over the last five or six year period. Those investments were prudent. They were -- they anticipated the growth that we now see, and capitalizing on those investments is exactly what we're all about right now. It's manifesting itself and the revenue increase, earnings increase. And that's why I am, and our leadership team is so focused on margin improvement.

Cai von Rumohr

I think you had a good cash flow year last year. You're talking about a 100% conversion this year, and then ‘25. What are the key drivers there?

Phebe Novakovic

So we have good cash flow conversion across almost all of our businesses. The large -- the major in our current plan, foreseeable investments at the Marine group are largely behind us. There might -- there're likely to be some more given the increase in submarine demand, but we'll work over time with our Navy customer. We fully factored all of that into our a 100% conversion. We'll be a very strong converter of cash for the foreseeable future.

Cai von Rumohr

And then, I mean, I followed you long enough where, I mean, when Nick was there, it was like, a 100% is like most of the time, because you have businesses with high returns on sale, so well managed.

Phebe Novakovic

It's all about cash, at the end of the day, it's all about cash. I mean, who here is going to disagree about that.

Cai von Rumohr

Finally, you've got the cash, you've got the balance sheet where it's looking pretty good. What do you use it for? I mean, obviously internal investment as required, but I mean, thinking about repurchase, M&A, special dividend, what are -- how do you think about how you would deploy it?

Phebe Novakovic

So I think our deployment plans are largely unchanged with the bias towards share repurchases, given the investments that we've made internally to our business. I don't see the facts and circumstances that would suggest a special dividend. Our board has always been very engaged in our dividend policy. I have no doubt that they will continue to be and

and we just never discuss M&A.

Cai von Rumohr

And what about M&A? I mean, you basically ran the M&A shop when Nick was there.

Phebe Novakovic

Well, I should -- for those of you who followed us for a while, you know that one of the first things we did when this leadership team took over was shut down our M&A, because a company that had been built on M&A had lost its discipline. We quickly regained that, but it had been very prudent. The fundamentals of making money on acquisitions again, do not change. There can sometimes be an impetus internal to the business for overpaying for a strategic investment. You hear strategic investment, you ought to run for the doors because all that means is that you're going to o overpay. So we've been pretty disciplined about M&A, and we'll remain.

Cai von Rumohr

What about niche fillers? Any sort of areas where you could use capability?

Phebe Novakovic

I think we're always looking for small bolt-ons that can be accretive and they can add to our portfolio. But I think you could gather by now both by inference and directly that we're pretty conservative when it comes to that, right? Cash is precious and how you deploy that cash is critical.

Cai von Rumohr

I think the fourth quarter was the first time I've heard you mention the word stock repurchase. And I think you've said in the past that you're disinclined to doing an ASR. How should we think about, when you talk about stock repurchase, you've been opportunistic. How should we think about, is this a billion? I mean, how should we think about how big or how important this might be?

Phebe Novakovic

I think our position on stock purchase will be as it always has been. We're very tactical about it, and we purchase our stock at appropriate intervals. And I think in this environment, that's probably the best we should say. I am not a big believer in announcing -- stock repurchases so everybody else can bet against you. I don't get at that. So, will be what we always are is prudent. And I think that that's a healthy way to be.

Cai von Rumohr

Terrific. I guess to conclude, so when you look at the outlook, it looks pretty good. What do you worry about in terms of, you mentioned kind of generating the cash and operating, but are there any particular things that you kind of are on your watch list of, we got a watch list to sort of make them numbers?

Phebe Novakovic

Well, clearly the supply chain has to continue to stabilize. But some broken record up here, but it's really about our ability to control the costs and that is what we are as a leadership team going to be focused on. And I think that's how you're going to drive real value creation and enduring value creation, not a particular pop. And then how you wisely invest your capital again to drive enduring value. I think that's our -- it's a very straightforward back to basics, fundamentals of providing for your customer, your on-time deliveries and rewarding your shareholders.

So this is -- I step back and look. This is about the best organic growth we have seen in this company, probably in since the Reagan buildup and this leadership team's focus on its operating performance. I think ensures and discipline capital deployment ensures that we'll see a nice growth pattern be ahead of us, and we're pretty excited about it, not without its challenges, but we are like, where we are right now. We like what we see. And it’s just about delivering on our promises.

Cai von Rumohr

Terrific, sounds good to me. Thank you so much, that was great.