General Dynamics Corporation
Q3 2011 Earnings Call Transcript

Published: 26 Oct 2011

[Operator:]

Good day, ladies and gentlemen, and welcome to the Third Quarter 2011 General Dynamics Earnings Conference Call. My name is Gina, and I will be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today, Nicole Shelton, Manager of Investor Relations. Please go ahead.

[Nicole Shelton:]

Thank you, Gina, and good morning, everyone. Welcome to the General Dynamics Third Quarter Conference Call. As always, 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 and 10-Q filings. With that, I would like to turn the call over to our Chairman and Chief Executive Officer, Jay Johnson.

[Jay L. Johnson:]

Thank you, Nicole. Good morning, everyone. General Dynamics delivered another solid operating performance in the third quarter, with sales of $7.9 billion and operating earnings of $998 million. Company margins improved 60 basis points from last year's third quarter and 70 basis points from last quarter to 12.7%. Earnings per share from continuing operations were $1.83 on a fully-diluted basis, $0.13 better than last year's third quarter. Third quarter free cash flow after capital expenditures was $15 million. This result was largely a timing reality caused by working capital growth and inventory at Gulfstream, associated with preparations for initial G650 green deliveries. We expect significant G650 cash payments in the fourth quarter in conjunction with the plane certification which will substantively reverse this trend. In our Defense businesses, I expect them to deliver their largest cash quarter of the year in the fourth quarter as we progress toward our annual goal of a 1

[L. Hugh Redd:]

Thank you, Jay, and good morning. I'd like to cover a few miscellaneous items before the questions and answers period. First, interest expense was $38 million for the quarter and $103 million for the full year. This puts us on track for expense of $140 million for the full year. We recorded $8 million of other operating expense, primarily associated with transaction expenses for acquisitions, and most particularly the Vangent transaction. The effective tax rate was 30.1, 3-0 point 1 percent for the quarter and 30.6% year-to-date. We expect the full-year rate to be very close to 31%. This quarter, we recognized a $13 million after-tax charge in discontinued operations resulting from the settlement of an environmental matter associated with the former operation of the company. Finally, during the quarter, we made voluntary contribution to the pension plans of approximately $300 million, consistent with our expectations at the end of last quarter. Nicole, that concludes my remarks. I'll turn it back to you.

[Nicole Shelton:]

Thank you. [Operator Instructions] Gina, could you please remind participants how to enter the queue?

[Operator:]

[Operator Instructions] And your first question comes from the line of Carter Copeland from Barclays Capital.

[Carter Copeland:]

Jay, I wondered if you might elaborate on 2 things. The first on the 280, you said you expect Israeli type certification early next year with U.S. to follow. That sounds later -- correct me if I'm wrong, but that sounds later than what we were talking about earlier. And does that change the production profile there at all? Or is this -- you're continuing on the existing production plan, will just get certification and have more green airplanes to deliver in the future.

[Jay L. Johnson:]

It's pretty much exactly as you said, Carter. It is a little bit later. It has to do with the sequencing of those certifications, and I don't expect that to impact the production rate. So we're working that with both -- obviously the Israeli regulators and the FAA. But we're on stream. And as I said in my remarks, we're thrilled with the airplane. It's just getting through the approvals.

[Carter Copeland:]

And what's the real source of the change in schedule?

[Jay L. Johnson:]

I think it has to do, honestly, with software upgrades and when they feather in, and what's required by the Israelis and the FAA. And I think just flowing all of that, to be very pragmatic about it, pushes it into next year.

[Operator:]

Your next question comes from the line of Jason Gursky from Citi.

[Jason M. Gursky:]

Just on Vangent, I was wondering if you could walk us through a bit more of the strategic rationale behind the price that you paid for it. And then lastly, some of the synergies that you would expect over some time.

[Jay L. Johnson:]

Well, I talked to some of that, Jason. But I mean, basically -- first of all, we believe we paid a fair price for it. And we're very glad to have Vangent in the portfolio, most importantly. It allows us to compete as a Tier 1 healthcare IT provider, okay? That's the underlying foot stomper, okay? It puts us at scale where we really can compete. It also gives opportunity in serving the fed civ customer base, both back office and customer facing, in areas like student loans, Medicare and Medicaid. So we believe there will be lots of synergistic opportunities, as I said in my remarks, in the fast-current lanes that are becoming much more obvious in that space. So Vangent is going to be a good add for us. We've worked some -- we are working the integration right now with the existing GDIT organization, if you will, and we like the prospects we see ahead. We're very bullish on it. And as you heard me say, it comes into the financial fold here starting in this quarter, fourth quarter.

[Jason M. Gursky:]

Are there any cost synergies associated with the transaction?

[Jay L. Johnson:]

I mean, some elimination of some of the corporate expense perhaps. But it's mostly opportunity that we're after here.

[Operator:]

Your next question comes from the line of Ronald Epstein, Bank of America Merrill Lynch.

[Ronald J. Epstein:]

Jay, just when you look at, I guess, the global economic backdrop and some of the uncertainty that we've seen in -- a slowdown in China. Maybe, maybe not. What impact have you seen or not in terms of demand on the large-cabin jet?

[Jay L. Johnson:]

To be straight up with it, Ron, I mean, we've seen no negative impact whatsoever. And as I've said before and talked in terms of the bifurcation of the business jet market, our large-cabin business is very strong and just continues with that. This is the largest order -- albeit we've got a big Minsheng number in there, but it's the largest order book number we've had since 2008. So the large-cabin business is very strong. And it's really heavily weighted to Asia Pacific, as I said in my remarks. But honestly, if you take the Minsheng order aside and look at the rest of it, it's pretty well dispersed

[Ronald J. Epstein:]

Okay. And what incremental demand have you had for 650s, say, over the last quarter or 2?

[Jay L. Johnson:]

I think I'd characterize it just by saying there's continued interest and activity, and the backlog number continues to increase somewhat. I mean, when you got over 200 in the backlog to start with, you don't expect a lot of add to that. But by golly, it's adding, okay? So there's still great attractiveness out there for the 650 and our in-production 450s and 550s. And you've heard me talk about the backlog sweet spot, if you will, of 18 to 24 months. Hey, we're still there, okay, with the in-production large-cabin. So it's a very bullish large-cabin market right now.

[Operator:]

Your next question comes from the line of Doug Harned with Sanford Bernstein.

[Douglas S. Harned:]

I'm interested on the cost side, actually 2 aspects of this. One is, if you could talk a little bit about the cost initiatives that you're driving from corporate across the businesses and how you're pushing that, because that sounds like a big theme here, given your discussions about the defense budget outlook. But in particular, Marine, you've gotten very impressive margins there, even with product -- program transitions underway. Is this being driven heavily by cost? Or how is that -- how have you done that?

[Jay L. Johnson:]

Cost and performance, I mean, that's the best way to say it and particularly to the last part, to your Marine question. You know, Doug, from watching our Marine group operate over the years, that they are very disciplined in managing those yards for profitability. And they do it extremely well. And that, plus the performance on the contracts that they're executing, allow those kind of margins. Now we talked about mix shift coming, and that will be a factor. But we've -- we also -- we still believe this is a business that will show us, even with the mix shift in DDG 1000 versus 51s, and MLPs versus T-AKEs, and Block III versus Block II Virginia-class submarines, we are still talking about a 9% to 10% margin business at least.

[Douglas S. Harned:]

But this sounds considerably better than, I think, you saw the business, say, 6 to 9 months ago in terms of performance. What's happening that has really improved that?

[Jay L. Johnson:]

It's back to cost management and performance and T-AKE, as we get to the end of the T-AKE line. And it's also -- I would add that it's also their ability to outperform their CEO's somewhat conservative lay-down in the start of the year.

[Operator:]

Your next question comes from the line of Cai Von Rumohr with Cowen and Company.

[Cai Von Rumohr:]

So the Minsheng order, I guess some other guys who have orders from Minsheng have provisions that that's cancelable. Are there -- can you give us some color on that transaction? I mean, are there any outs for them? And secondly, is there additional potential from either Minsheng or others that you see near-term in China?

[Jay L. Johnson:]

Well, I think the answer to the last, Cai, is yes. We see the opportunity set in China continues to grow as the Aerospace business in China, the business -- Aerospace business continues to grow. And as to the first, I mean, we have very good terms and conditions on our contracts and liquidated damages clauses, et cetera. So we feel very adequately protected, if you will, with this order and frankly, the rest of them we have in our book. We're very mindful of that, particularly when you have numbers like we're talking about here. But it's spread across the product line, and they're very eager to get their airplanes. So we feel good about it right now.

[Operator:]

Your next question comes from the line of Heidi Wood with Morgan Stanley.

[Heidi R. Wood:]

Jay, a question on the international markets. Again, I just want to get a little bit more bead on how you would characterize the Asia-Pacific demand in commercial. Is it as strong in '11 as it was in '10? Do you see it ramping up? And then the second part is on defense. We've obviously seen a lot happening in the Middle East. And how is this affecting the pace of international competitions? And which would you highlight as the most imminent or important for you to land?

[Jay L. Johnson:]

As to your first, Heidi, I would say yes and yes to your questions. I mean, we are seeing increased activity, pretty steady in Asia Pacific, with Minsheng being fairly typical of that. But you and I, we've talked before about things like the projections for airport growth in China, for example. And the earlier projection I saw in the year had like -- I think it was 10 airports a year that they were projecting to build. The number I'm seeing now is higher than that. I don't know if that tracks with what you see. But it could be like 15 a year. So the point of it all is that we are seeing increased activity in Asia Pacific, and as I mentioned earlier, from a large-cabin perspective, and really now starting with the 280 from the other areas of the globe as well. The defense side, international is kind of a -- let's see, how would I characterize that? The growth area right now in international is in the Middle East. I mean, that's unequivocal, okay? Our European business is mixed. Not surprising. We've talked about that before, because of the fiscal conditions in which they're operating. Their requirements are fairly well -- very well-defined, but the fiscal realities are preventing some of the contract lay-downs that they need and we would like to see executed. That gets pushed to the right. But having said that, our indigenous business, as I highlighted with Canada on the LAV contract, the production contract that just got laid down, is very good. The TAPV is proceeding right after that with -- for selection within the Canadian forces. And so there are mixed messages perhaps in some of what I'm suggesting, from Europe in particular. But the Middle East market continues to grow and continues to execute very well for us. And that's in more than one place, as you probably know. So we see that as probably key to our international book of business in the Combat Systems group, going forward. As the U.S. market flattens to declines, the indigenous European market stays flat, the ammunition market comes under some challenge in the short term just to burn off inventory that it has right now. You're going to see the growth coming out of the Middle East.

[Heidi R. Wood:]

And just quickly on that, what percentage of Combat Systems, international, is it in '11? And what does it look like in '12?

[Jay L. Johnson:]

The number I've got in my head is around 30%, I think, right now in '11, of international sales. And as you -- I don't have a '12 number, but the projection I looked -- out a few years, when we last -- when they last showed it to me, was in the mid- to upper 30s. So it's growing as a percentage of their book of business going forward.

[Operator:]

Your next question comes from the line of Pete Skibitski from SunTrust.

[Peter J. Skibitski:]

Jay, on the guidance for this year, are you guys basically factoring in 0 for the share repurchases?

[Jay L. Johnson:]

I don't really factor share repurchases in when I do guidance. If that's what you're asking me, yes. So my answer would be yes. Now having said that, we have the authority and the wherewithal to do so tactically as we always do, if the market suggests that it's time to buy back some shares. But the answer to your question is yes.

[Peter J. Skibitski:]

Okay. And a question on margin. Fourth quarter in Combat sounds like it's going to be really, really strong from a top line perspective. It just seems like kind of 14% margin rate is really conservative. I mean, shouldn't we be thinking more like 15% or so for the quarter?

[Jay L. Johnson:]

Well, I'm pretty comfortable, I think, with what I said overall. And it has to do with timing of, shall we say sunsetting of some programs that showed themselves in the third quarter. EFV comes to mind and perhaps FCS. So that's why I'm tamping myself back down to what I'd call more normal in the fourth quarter and for the year.

[Peter J. Skibitski:]

Understood, understood. If I could sneak one last one in, because I'm really confused in IS&T margins. If services are doing really well and products poorly and yet margins were up to 11.6%, and given the margin differential there, I mean, shouldn't we be thinking 11.5% or so as sustainable given what you're doing on this type of mix?

[Jay L. Johnson:]

It's another one where you've got some timing here in terms of the programs that delivered, that helped us deliver. You've got cost-cutting initiatives that I discussed in my remarks and performance that helped us drive the margin. But you've also got -- in this quarter, 3Q, you've got some program -- not termination -- I'll use the term sunsetting again, like WIN-T Increment 1 that gives you a margin lift there that you probably won't represent again in the fourth quarter. So I think I'm comfortable with the margins that I've laid down.

[Operator:]

[Operator Instructions] And your next question comes from the line of Michael Lewis with Lazard Capital Markets.

[Michael S. Lewis:]

Jay, just to stay on the Combat Systems point. In your prepared remarks, you comment about the FMS LAV orders, also some pretty significant logistics work that's out there. Should we expect these orders to all book in Q4? And also, will the book at year end be enough to support flattish revenue moving into '12?

[Jay L. Johnson:]

I'm not ready really to talk in any detail about '12. I mean, as I said in my remarks, I'm encouraged by what we've got in the order book and what's coming to the order book, even post Q3, that tees us up for 2012. But beyond that, I don't think -- I don't see a precipitous decline, as we've discussed in the past. But I'm not ready to give you any hard numbers for 2012 yet. But I do think that the order book that we've seen, we're expecting Q4 orders for more FMS tanks, for example. We expect the Egyptian Increment 11 to come to closure here -- I mean literally within days, perhaps. So these things are moving forward. We expect more Stryker consideration on the support side and/or the NBCRV that we talked about -- that I talked about in my remarks. So I think another tranche perhaps of LAV from the Middle East. So we've got a lot that's pending that we're confident will come across. It's just a question of the timing space, 4Q or into next year.

[Operator:]

Your next question comes from the line of George Shapiro with Access 3

[George D. Shapiro:]

Jay, if you looked at IS&T, where it's down 2% or 3%, I'm assuming Vangent's $200 million in revenues. So you're looking for, without Vangent, another relatively weak quarter. Is that all due to the tactical communications area? And how much is that area actually declining by itself? It must be a pretty substantial amount.

[Jay L. Johnson:]

Well, honestly, George, I think what you're seeing in a lot of it here is -- I would call it a combination of CRA timing and customer behavior. What does that mean? That means that what we're seeing -- and I alluded to it, or -- quite directly, I think, in my remarks, you're seeing prolonged acquisition cycles, shall we say. The time between bid and proposal, and then actually award or task order has increased 50%, 100%, 150%. I mean, for example, one of the large awards that we've received in this space, we were the only bidder and it still took over a year to bring that award forward. So that's just a timing reality that they're all dealing with in it. Particularly important, as I said in my remarks, is some of the mobile computing and ruggedized equipment

[Operator:]

Your next question comes from the line of Howard Rubel with Jefferies.

[Howard A. Rubel:]

Jay, just to touch on Marine -- actually, just to touch actually and expand a little bit on your efforts at sort of managing costs. And it's not just at Marine, it's also at Combat, these sort of levels of profitability. What other opportunities are you doing that's just looking for opening the aperture to do things, either like what you're doing with Marine on service or booking of other Combat vehicles that you can bring technology to for upgrading?

[Jay L. Johnson:]

Well, we're always -- look, as I said earlier, we, Howard -- particularly as it applies to Combat Systems, we compete very favorably for all the new stuff, okay, all the new development programs. That's why we're players in Ground Combat Vehicle. But we also know how to work with our customer to service what's already there. Our incumbency puts us in a very strong position there. Double-V hull, Stryker V is a classic example of something that was already there that needed to be enhanced. We enhanced it for the customer. So we're constantly looking for things like that. As to the businesses, and I think to your earliest point, look, you know our model. It's very decentralized. There's great authority and responsibility at the business unit level, and they are working very diligently to manage for profitability. And we've reduced headcounts, we've reduced overhead. And we'll continue to go do that as we go forward to make sure that we can still deliver the results we need for our shareholders.

[Operator:]

Your next question comes from the line of Joseph Nadol with JPMorgan.

[Joseph Nadol:]

Jay, just back to the tactical communications. How much of the shortfall in what you maybe expected 6 or 9 months ago is, do you think, just reduced demand from the field as OCO outlays slow? And how much of it is just program-specific delays? And to the degree that it's program-specific delays, could you talk a bit about which programs? I mean, is this HMS? Is this WIN-T? Is it others? Is it a whole bunch of things? And then finally, just looking at OCO in general, what do you guys estimate your OCO spending exposure is in 2011?

[Jay L. Johnson:]

The OCO number in 2011 I don't have off the top of my head, honestly. But I'll just say it's not substantive, in the broader sense. And we've said before that a lot of the OCO that moved away, for us, because of the incumbency that we have, moved back into base budgets. So I mean, our programs are fairly well supported in that regard. To your point about the reduced pull from the field, look, we're very -- our JTRS HMS and WIN-T are very much, shall we say, in demand. You know that #1 priority that the Army has right now is for their network, and that's what we're talking about. So there's another network integration exercise here next month. We are already in LRIP on producing 6,250, as I recall, Rifleman radios, and 100 Manpack PRC-155s. That will come to another production decision earlier in the year after this next exercise. And so we're very bullish on those products. Some of the others, to your first point, it has been manifest because of the acquisition delays that I talked about. But we feel very strongly that our WIN-T and JTRS HMS programs are being very well supported and pushed by the Army. They need them.

[Operator:]

Your last question will come from the line of Rob Spingarn with Crédit Suisse.

[Robert Spingarn:]

Jay, 2 quick things. First, the talk about potential expansion of Virginia class to 40, 50 boats. What kind of impact benefit might that have for you? And then I have a quick one on Gulfstream.

[Jay L. Johnson:]

A good one. I'm not being smart-aleck about it. Look, we've talked before, Rob, that right now, there are 30 Virginia-class boats in the plan. That clearly does not meet the requirement that the combatant commanders need out there. So going beyond that, I think, is a very logical national security priority. You might expect a former Navy guy to say that, but in point of fact, I believe the combatant commanders validate that virtually every day. So I think the likelihood of expansion beyond 30 is very real. How that all feathers in, how it mixes with SSBN, what you do, when you do it, all that to be determined. But I think from a strategic prioritization, that makes sense at 2 per year, okay, Virginia class.

[Robert Spingarn:]

Could that somehow or another improve cost in the near term? Somehow something gets deferred out into later boats if we get a decision in that direction? And then the last thing I wanted to ask you...

[Jay L. Johnson:]

Rob, just a second. The cost piece, to me, the best way to manage the cost on that program is to stay at 2 a year.

[Robert Spingarn:]

Okay. And then quickly, what would be the timing on the G450, G550 refresh? And is there some R&D already flowing on that?

[Jay L. Johnson:]

Oh now, Rob, you know I'm not going to answer that question.

[Robert Spingarn:]

Honeywell is already talking about some anticipated avionics awards, so...

[Jay L. Johnson:]

Look, here -- you know that we are very consistent in product development commitment at Gulfstream. That's my answer. We nominally take 2% of sales, whether the top line's going up or down, and commit to product development. We continue to do so. And there'll come a day when the 450 sees a new airplane out there, and the 550; and many, many years from now, the 650. But we continue to refresh these aircraft. Example, out at NBAA, we have something we call Phoenix, which is basically an upgrade enhancement to the interior of the 450 and 550 that is really, really nice, if I do say so myself. That basically puts the cabin management system and the cabin itself -- the galley's upgraded, in the same package, if you will, as you see in the 650 and the 280. So we continue to do that even with the in-production aircraft as we develop product going forward. And we'll stay with that. That's how you stay as the premier brand, and that's how you continue for the long haul in this business. And we've been capitalizing smartly our Gulfstream business since we got it in '99, and we'll continue to do that going forward.

[Nicole Shelton:]

I'd like to thank everyone for joining our call today. If you have additional questions, I can be reached at [phone]. Have a great day.

[Operator:]

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.