General Dynamics Q1 2009 Earnings Call Transcript

Apr.29.09 | About: General Dynamics (GD)

General Dynamics (NYSE:GD)

Q1 2009 Earnings Call

April 29, 2009; 11:30 am ET

Executives

Nick Chabraja - Chairman & Chief Executive Officer

Hugh Redd - Chief Financial Officer

Amy Gilliland - Vice President of Investor Relations

Analysts

Sam Pearlstein - Wachovia Securities

Noah Poponak - Goldman Sachs

Peter Arment - Broadpoint AmTech

Howard Rubel - Jefferies & Co.

Cai Von Rumohr - Cowen & Co.

Ron Epstein - Merrill Lynch

Carter Copeland - Barclays Capital

Doug Harned - Sanford Bernstein

Myles Walton - Oppenheimer

Joe Nadol - JP Morgan

Robert Stallard - Macquarie

Robert Spingarn - Credit Suisse

Presentation

Operator

Good day ladies and gentlemen and welcome to the first quarter 2009 General Dynamics earnings conference call. My name is Dan and I’ll be your coordinator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions)

I would now like to turn the call over to your host for today’s call, Ms. Amy Gilliland, Staff Vice President of Investor Relations; please proceed.

Amy Gilliland

Thank you Dan and good morning everyone. Welcome to the General Dynamics first quarter conference call. I want to remind listeners that as always, any forward-looking statements made today represent our best estimate 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’d like to turn the call over to our Chairman and Chief Executive Officer, Nick Chabraja.

Nick Chabraja

Thank you, Amy. Good morning. I’m obviously pleased with the first quarter performance at General Dynamics. We’re off to a strong start in what promises to be another good year.

With respect to revenue sales we’re up 18%. We had double digit top line growth in each of our four operating segments, when compared with the first quarter of 2008. I might point out Combat’s and Marine Systems, the volume was particularly strong as they both topped 20% sales growth in the quarter.

Earnings per share from continuing operations grew 8.5% to $1.54 on a fully diluted basis. This earnings growth is to me particularly impressive, because it comes on top of a 33% growth in fully diluted EPS in the first quarter of 2008 of the comparative period. So we experienced good growth on top of really marvelous growth.

Backlog; the company’s backlog at the end of the quarter totaled $71 billion, 43% higher than where the backlog stood at the end of the first quarter 2008. In the quarter, we had healthy order activity in the IS&T and Combat Systems groups and that helped offset slower Aerospace orders. When combined with $17.9 billion of potential contract value, the total estimated contract value at the end of the quarter was an impressive $89 billion.

Cash, we’re a little weak. The company generated $73 million of cash after capital expenditures in the quarter. I would point out that cash is generally weaker in the first quarter, and particularly strong in the second half of the year. I expect that pattern to repeat itself again in 2009. To give you a little color, the defense businesses cash production was very strong in the quarter, but the aerospace businesses, both of them were significant users of cash in the quarter.

Let me speak to the performance of each of the four segments briefly, and then we’ll get to your questions and some additional remarks that Hugh has planned for you. Combat Systems; this was another strong quarter for Combat Systems, with revenue increasing 20.5% year-over-year. Nearly 50% of the sales growth in the quarter came from increased Abrams and Stryker volume; right in the core. The organic growth in the group was 13.7%. With the rest coming from AxleTech and acquisition we completed in the fourth quarter last year.

The first quarter revenue growth is consistent with our revenue guidance of 20% to 25% for this segment. Operating earnings also grew nicely in the quarter, albeit at a rate slower than sales. Consequently, the group’s margins declined 140 basis points to 11.6%. This compression was caused by a mix shift in the group’s workload for the quarter, primarily attributable to MRAP volume at lower margins than those achieved during the first quarter of 2008. 2008 you might recall we had the highly successful Cougar program.

I think I would also add that maybe Europe didn’t do as well as we had expected this year, as a result of a couple of operating issues in the quarter, but I think they’ll be back on track as we go through the year, and they tend to build during the year because they’re on the units of delivery accounting methodology, which somehow seems to result in fairly irregular performance, but heavily balanced towards the end of the year.

For the entire group, I expect margins to rise quarter-by-quarter throughout the year. Consequently, full year group margins, consistent with our previous guidance of approximately 12.5%, appear achievable.

Combat Systems backlog stood at $14.5 billion at the end of the quarter. We expect to add $1.5 billion, principally arising out of Saudi Arabia and light armored vehicles and tanks before year end. There are numerous other opportunities, including additional foreign military sales to Iraq on the horizon, which present upside to our current outlook.

Maybe let me conclude my remarks with respect to this segment by talking a little bit about MRAP. MRAP has been for us a great adjacent market opportunity. The company has been able to earn a healthy return on very little capital investment, in a market in which we never previously participated. Together with our partner, force protection, we were selected to compete for work in the follow-on MRAP ATV or MRAP light competition. This provides us some continuing opportunity to participate in this tactical real vehicle market.

Moving over to Marine systems; Marine systems first quarter was superb, as the shipyards continue to far outperform expectations. Sales and operating earnings improved in each shipyard when compared to both the first and fourth quarters of 2008. Operating earnings grew nicely or grew nearly 34%, significantly outpacing the group’s strong 21% sales growth in the quarter.

The operating margins improved 90 basis points over the first quarter 2008, and this tremendous operating leverage is particularly impressive because it is the result of improved execution across the board on the programs at each of the shipyards, including Virginia class submarines, DDG-51 destroyers, TAKE and the commercial product carrier.

The Marine Group’s backlog was $25.5 billion at quarter end. Backlog does not include the two additional DDG-1000s and one additional DDG-51 that were mentioned as part of Secretary Gates budget preview remarks. These ships when under contract will provide Bath Iron Work, with workload stability for many years to come.

With this strong performance under their belt, I feel confident that the Marine group will achieve the 9.7% to 9.8% margins that were implicit in my previous guidance to you. Early indications suggest that our sales guidance of 5.5% to 6% was conservative, and that volume could provide some significant upside here, together with some possibility that they’ll outperform on the margin front.

On the defense side, the last business or groups that we’ll speak to are information systems and technology. First quarter sales for IS and P grew 16% over the same quarter last year. The organic growth rate was 13.7%. All three North American based businesses bested not only their first quarter 2008 sales and operating earnings, but fourth quarter 2008 as well.

A shift in the group’s contract mix resulted in a 50 basis point decrease in operating earnings compared with the year ago quarter. The group’s 10.6% margin performance however exceeded my expectation. I’m pleased to report that this is a result of strong execution across all of the businesses.

Book-to-bill for the group was 1.1 this quarter, continuing a pattern of strong demand for IS&T’s products and services. The group’s order intake exceeded one to one in three of the previous four quarters and was 1.12 for the full year 2008. This growing backlog positions IS&T for continued strength in 2009 and beyond. So they’re off to a great start. I believe IS&T will achieve, if not better, the 8% revenue growth we have forecasted. They also have some opportunity to outperform my original guidance of 30 to 40 basis points margin compression from last year’s 10.7 average.

Last, Aerospace; the aerospace group held its own this quarter. A noteworthy accomplishment I think, in light of business market conditions. While conditions are by no means good, I am pleased to report that they have improved materially from what we experienced in February. Positive data points from our Gulfstream team include improved Gulfstream flying hours, signs of thawing in the pre-owned market, and increased customer interest in new orders.

The addition of jet aviation to the group’s results caused sales to grow 13.8% year-over-year. Gulfstream’s revenues were down, although inline with our expectations, given our planned production cuts. Gulfstream’s service volume was also down, although modestly less than 9%. By the way, Gulfstream’s revenues were down in the area of 8.5%, probably should have mentioned that.

New aircraft deliveries in the quarter were consistent with our production plan for the year, as we were able to cover defaulted contracts with new orders or move up buyers. All but one aircraft for first quarter delivery delivered as planned. That one, a G-550, a white tail at quarter end, now is under contract and will deliver in the second quarter.

The group’s operating earnings were impacted by several irregular or unusual items at Gulfstream, including employee severance costs about $10 million, lower launch assistance payments than we had received first quarter a year ago, lower by about $12 million, and negative fair market value adjustments on four pre-owned aircraft in inventory, totaling $21 million.

These negative items were partially offset by receipt of payments for liquidated damages on defaulted contracts, totaling approximately $30 million. I think in that mouthful, I’ve given you the four sort of unusual items in the quarter that you can use to balance your evaluation of performance.

We had seven pre-owned aircraft in inventory at the end of the quarter and there are five additional inputs anticipated through the remainder of the year. While that is higher than recent years, we have significantly reduced our pre-owned exposure, compared to the last downturn.

The group’s operating margins were 13.7% in the quarter. Margins were pressured obviously by the addition of jet aviation and to a lesser extent the aforementioned pre-owned aircraft charges. Margins in the group would have been 15.2% without pre-owned.

We are working very aggressively to integrate and improve upon jet aviation’s performance, particularly in their completions work. I believe that jet will improve their operating earnings contribution in each quarter during the year.

Gulfstream’s new aircraft margins were actually up in the quarter. Even when we exclude all unusual items that bear upon new aircraft margins, new margins were slightly improved when compared to the year ago quarter; an impressive performance in this market. Gulfstream book-to-bill expressed in dollars was 0.6 times for the quarter, as modest order activity was outpaced by aircraft deliveries and some customer defaults.

All totaled, the backlog eroded somewhat in the first three months of the year, ending the quarter at $20.8 billion. Over the last several weeks, the backlog has stabilized significantly, and I believe there is less risk to our production plan for this year and next, than when we announced the production cuts in early March.

I expect the second quarter at aerospace to be as good as or better than the first. As you know, we plan to furlough the manufacturing workforce at Gulfstream this summer, which will make the third quarter weaker. Our furlough approach is well received by the employee base, and it affords us a great deal of flexibility to adjust duration based on the level of order activity. So for example, if new order activity improves, we will shorten the furlough period.

I feel confident that we are proactively confronting the spectrum of challenges presented by the current business jet market conditions. I am pleased to report that new aircraft development is on track, and I expect that the G-650 will fly before year end. I believe that current market conditions and backlog stability support the production levels set for 2009, with some modest upside potential in 2010.

I think, in short this was a very good quarter for us. The defense segments mature and developing product portfolio address both conventional and irregular warfare requirements, consistent with the views expressed by Secretary Gates, while the aerospace business is continuing to invest in new products and technologies that will entice business jet customers for years to come. In short, I believe that our backlog, healthy balance sheet and diverse products and services position General Dynamics to benefit from myriad opportunities in all of its markets.

Before I take your questions, I’d like Hugh Redd, our CFO, to fill in some details that may be of interest to you.

Hugh Redd

Thank you, Nick. Interest expense for the quarter was $39 million; it was twice the amount for the first quarter of 2008. The increase in interest expense is a result of increased net debt required to fund acquisitions and share repurchases during 2008.

Additionally, during the first quarter of 2009, we repurchased 2.1 million shares and completed a minor acquisition in the IS&T segment. As a result, net debt increased just over $300 million, and notwithstanding this increase in net debt, we still expect the interest expense to approximate $150 million for the full year.

On the tax rate, the effective tax rate for the quarter was 31.8%, consistent with our expectations. For the full year we continue to expect the rate to approximate 31.5%. During the first quarter of 2009, our return on invested capital and return on equity improved 40 basis points and 70 basis points respectively. ROIC was 150 basis points better, and our return on equity, ROE, was 200 basis points better than one year ago.

Finally, I want to point out that in the press release, Exhibit H to be a little more precise, we presented Gulfstream only data to facilitate your year-over-year comparison. We’ll have to rethink that disclosure and we have a full quarter of jet aviation in both the current and previous years, but again, we’ve given you Gulfstream-only data for your comparison purposes.

Amy that completes all my remarks.

Amy Gilliland

Thank you, Hugh. Before I move to the question-and-answer period, I’d like to ask participants to ask only one question, so that everyone has an opportunity to participate this morning. If you have additional questions, please get back into the queue.

Dan, could you just please remind participants how to enter the queue?

Questions-and-Answers Session

Operator

(Operator Instructions) Your first question comes from the line of Sam Pearlstein from Wachovia. Please proceed.

Sam Pearlstein - Wachovia Securities

Good morning. Nick, I just wanted to follow up on Marine. To what extent was this an acceleration and a timing issue versus real improvement, because I’m trying to just reconcile the growth this quarter with a 5%, 5.5% growth year, which I know you say is conservative and trying to think about the moving pieces as we go through the year.

Nick Chabraja

Sam, I can’t see any move ahead. I parsed that. This is a conversation I’m going to be having with Dave Hebner and the shipyard Presidents, but it would appear to me that the volume is repeatable, but I haven’t gotten to ground truth yet. The margins were what I had anticipated and they reflect the modest booking rate increases, pretty much across the product base from production efficiencies, but I’m not prepared as you could tell from my earlier remarks, to declare victory on revenue volume just yet, until I work that issue a little further.

Sam Pearlstein - Wachovia Securities

Okay, thanks. I’ll stick with one.

Operator

Your next question comes from the line of Noah Poponak from Goldman Sachs. Please proceed.

Noah Poponak - Goldman Sachs

Hi. Nice quarter.

Nick Chabraja

Thank you, Noah.

Noah Poponak - Goldman Sachs

At combat, you’ve talked about a lot of opportunities there. It seems like the range of outcomes here is pretty wide. You just mentioned the Saudi and the direct Iraq sales. Maybe update us on some of the opportunities that arose during the quarter, specifically what the FCS vehicle cancellation means for you in the near term, what the sole source removal on ECB2 means for you potentially and where we stand on METB?

Nick Chabraja

That’s a whole mouthful I guess. I don’t know what to say about future combat system. We continue to work on FCS under our existing contract. I don’t have enough clarity; we’re not faced with any stop work order, so we’re proceeding with the research and development work that we previously have been doing.

You know the outcome of the Army’s deliberations, with respect to their future combat vehicles, you know more than I do. My understanding is that the Army is working that close quarters and they’re discussing it with the Secretary, but not with industry. So I can’t shed any light on that.

I think most of our programmatic activity is moving ahead, as anticipated. I didn’t see anything particularly unusual. Most of the upside to our plan comes from international order activity and the potential for it. To say that something cropped up in the quarter is unusual. Things don’t usually crop up in this business, they develop over time and we’ve been talking about the Saudi Arabian potential.

Yes, I guess the 140 tanks for Iraq, maybe we could say that grew in the quarter, but there have been discussion before then. There’s an option for another 140. The MRAP ATV opportunity I think is probably first surfaced publicly in the quarter, but there had been discussion in the past.

Noah Poponak - Goldman Sachs

What transpired on ECB2, an opportunity for GD?

Nick Chabraja

Look, there’s a lot of opportunities out there and what happens with joint tactical vehicle and the split of vehicles. I think Noah, until the Army gives clarity to their modernization program, with respect to wheeled and tracked vehicles, any answer I give you or any speculation that you bake into your analysis is dice rolling, we just don’t know. It’s going to be a robust market; that we know. What it will be made of, we don’t know. So let’s wait for the Army to tell us and then we can all handle it.

Noah Poponak - Goldman Sachs

Fair enough. Thanks, Nick.

Operator

Your next question comes from the line of Peter Arment from Broadpoint AmTech; please proceed.

Peter Arment - Broadpoint AmTech

Good morning. Nice results. Nick, maybe this falls in the dice rolling category also, but Ohio class replacement was mentioned with Secretary Gates and this is clearly a long term opportunity, but has there been any details discussed on how they plan to move forward with that and what actual funding will be involved?

Nick Chabraja

We have for some time Peter, been at work with our ally, the United Kingdom, on the design or portions of the design work of a replacement to the Ohio class, and I was pleased and encouraged by the Secretary’s public remarks on something that had been reasonably quiet until then and we look forward to more detail when we see the FY ‘10 budget.

Peter Arment - Broadpoint AmTech

Okay, and just quickly, if I could quickly follow up. I guess on IS&T, cyber security made a lot of headlines and I know you’re in a lot of classified areas, but is there any general color how you see any incremental funding coming through for you?

Nick Chabraja

I don’t think so. I think we’ve been a significant player in that world, and I think to give you a little color, we generate about $1 billion annually, in the general subject of keeping intruders out of US computer networks and encrypting military communications.

So that gives you an idea of the size of our participation in the market. We do that through a number of programs, mostly classified, and I think probably I’ve said enough on that subject. We don’t do a lot of crowing about cyber security, but I think we’re a pretty strong participant.

Peter Arment - Broadpoint AmTech

Good enough. Thank you.

Operator

Your next question comes from the line of Howard Rubel from Jefferies & company. Please proceed.

Howard Rubel - Jefferies & Co

Thank you very much. Nick, just to go to Gulfstream for a moment, you provided a little bit of color about the market getting better, could you add a little bit of depth to that in terms of customers coming back and dialogues becoming richer and what do you think the customers have seen, that’s giving them confidence again to use the product?

Nick Chabraja

I don’t know that I can get into the customer’s mind Howard, but look, the most important thing from our perspective is we had a terrible blood letting in February, with a number of defaults and requests for cancellation, and requests to be further back in line. That created an enormous amount of work and energy and caused us to change our production plan. We were able to handle that I think, and we see that activity has quieted, and we have more confidence in the remainder of the backlog, now that we’ve been through this sort of purging.

What I can tell you Howard, is what another major shock to the economy would do, but absent that, we have a higher degree of confidence in this backlog, now that there’s been some pruning gone on. We see buyers returning to the market. I have no idea what gives them confidence.

There are sort of two markets in creation out there; one is a spot market, where the prices are slightly off, sometimes more than slightly. Then for our aircraft, there’s a longer term regular market to participate in the ordinary way in the backlog. Those prices are remaining reasonably firm. So there are buyers with different motives.

Some buyers who might otherwise be buying pre-owned aircraft and see an opportunity to get a new airplane at distressed prices and may be taking advantage of default environments as replacement buyers. Those buyers don’t get to configure the plane themselves or get to outfit it just the way they might have done it, but they find the purchase point attractive in that venue.

We’re happy to see those kinds of buyers, because they help us, and frankly they help the party who’s in default to get through what probably is a tough economic environment, but we’ve seen that occur, and we’ve seen people now expressing more interest in product in the normal course.

So I don’t know; I can’t put myself in the heads of these customers and I don’t personally deal with them, but they’re reappearing, albeit slowly. I don’t want to claim victory here. It is much, much too early.

Howard Rubel - Jefferies & Co

Was this book-to-bill, was it spread across the product line or was it more area more than another?

Nick Chabraja

No, it was spread across the product line Howard, and it was very helpful.

Howard Rubel - Jefferies & Co

Thank you very much.

Operator

Your next question comes from the line of Cai von Rumohr from Cowen& Co.; please proceed.

Cai Von Rumohr - Cowen & Co.

Yes, thank you. Good quarter, Nick. Could you give us some more color on where R&D was? It looks like it was up year-over-year, specifically in Gulfstream.

Nick Chabraja

Yes, it was. I’ll give it to you here in a minute, as soon as I can lay my hands on it.

Cai Von Rumohr - Cowen & Co.

The other part of the question was, maybe give us some color going forward on employee severance. Is there more to come? Launch assistance, should you catch up or slip from the first quarter. Thank you.

Nick Chabraja

Cai I’m going to answer the first part of your question first and then I’ll ask you to repeat the second part, but yes, the Research and Development dollars were up about $17 million quarter-over-quarter and that’s a net figure.

You might remember in my remarks, I alluded to the fact that launch assistance was down $12 million, so that made the spread on net R&D dollars broader, but on gross dollars, we spent about five more than we had a year before, but from an economic point of view, you’re quite correct. This was significantly more than a year ago, near double.

Cai Von Rumohr - Cowen & Co.

Okay, and the second part of the question was looking forward, should the R&D decline as we go through the year and should we see more severance expenses?

Nick Chabraja

Our spending will remain reasonably constant. What you will see in the R&D category is more or less launch assistance by quarter. So that will be spotty and so I can’t predict for you right at the moment how it will be each quarter, but we’ll continue to spend at the pace that’s reflected in our first quarter results.

You will see more severance in the second quarter, because this severance took care of the first trench of cuts that we had planned and designated and identified. There will be a second grouping that will be executed in the quarter. If the layoffs don’t take place, the plan will be fully developed and identified, the employees who will leave, and that will be the end of the riffs. We will then do whatever adjusting to our production is required through furlough and that will be in the third quarter.

You may have heard in my opening remarks that I try to take all of that, roll it into a ball and say that I expect in aerospace the second quarter results to be as good as or better than this quarter. Third quarter results down as a result of the furlough and fewer deliveries in the quarter, to pick back up again in the fourth quarter.

Cai Von Rumohr - Cowen & Co.

Terrific. Thanks so much.

Operator

Your next question comes from the line of Ron Epstein from Merrill Lynch; please proceed.

Ron Epstein - Merrill Lynch

Yes. Good morning, Nick.

Nick Chabraja

Good morning Ron.

Ron Epstein - Merrill Lynch

Can you follow up on I guess another quick Gulfstream follow-up question: what did you see with regard to the customer reaction to the G-600 in the economic downturn? I mean, did you see anybody backing away from it or is it still so far out there that folks are still okay?

Nick Chabraja

We lost a couple and picked up a couple in the quarter, so that I think our backlog with G-650 is up marginally, and I think the backlog’s holding tough. We’ll see the first 50 or so have a payment due when we fly. We’ll see whether that holds up, but the customer interest remains tremendous and the principal inquiry we get is, “are you on schedule?”

Ron Epstein - Merrill Lynch

And that was my follow-on; how is that going?

Nick Chabraja

We’re in pretty good shape. We’re going to fly it before the end of the year.

Ron Epstein - Merrill Lynch

Super. Thank you.

Operator

Your next question comes from the line of Joe Campbell from Barclays Capital; please proceed.

Carter Copeland - Barclays Capital

Good morning, it’s actually Carter Copeland and Joe Campbell.

Nick Chabraja

Good morning Joe and Carter.

Carter Copeland - Barclays Capital

Nick, I wondered if we could ask you briefly about the performance of the two large acquired businesses, AxleTech and jet. You said you expected jet to get better over the course of the year, but any color there on how they performed in the quarter and what sort of improvements we expect to see in the year would be helpful.

Nick Chabraja

Yes, I think AxleTech performed very, very well. They have a commercial segment in their business, which experienced some volume issues, but they’re performing well, and I think will continue to perform better. There’s some obvious synergies between AxleTech and our group of businesses.

Jet aviation, volume was off slightly. I think it came in two parts. The MRO business experienced some softness just like Gulfstream did. The maintenance service business, they were off neighborhood of 10% from their expectations. In other respects, revenue was off principally as a result of foreign exchange, the relationship of the Swiss Franc to the dollar.

In operations, as I indicated earlier we were disappointed. We’re taking aggressive action there to integrate and boost their operating managerial talent and get them back on track and we have no question, but that will be accomplished.

Carter Copeland - Barclays Capital

Did the business make money in the quarter, Nick?

Nick Chabraja

Yes, it made money. Sure it did.

Carter Copeland - Barclays Capital

Great. Thank you.

Operator

Your next question comes from the line of Doug Harned from Sanford Bernstein; please proceed.

Doug Harned - Sanford Bernstein

On IS&T, could you walk through the three US units and describe what the drivers are that led to this good performance and how you see that playing out over the year?

Nick Chabraja

I don’t know how it’s going to play out during the year. Volume was up at all three significantly, driven by a lot of programmatic activity, most significantly at AIS, but it’s a potpourri of products and programs and I don’t know that it would further the discussion much for me to parse that. This is not a business like the big platform businesses, where we have two or three programs that drive our results. This is one where we have 5,000 and 6,000 contract line items over a given time.

Doug Harned - Sanford Bernstein

Well, what I was getting at is, are you seeing some trends you mentioned? There’s some benefits in the encryption arena before and I know in C4 systems you certainly do have a few larger programs like WinT. I was just wondering if there was anything you could point to here?

Nick Chabraja

No. One quarter doesn’t a trend make, and if we were going to make a trend out of anything, it would be out of my remarks that in four of the last five quarters, we’ve had a book-to-bill that exceeded one. If you’ve been following this for a while, I’ve had a long running dialogue with my friend, George Shapiro, who no longer provides coverage, about where was the organic growth in IS&T.

Well, finally we got it, and it came from those orders, all of which we publish with great regularity and you follow and they finally got funded by way of revenue.

Doug Harned - Sanford Bernstein

It looks like they’re getting funded better than even you thought though.

Nick Chabraja

That is true. More importantly, they’re funded better than they thought and they’re getting some wins out there and they’re managing to get some of their programs funded in the ordinary course and we’re seeing some of those awards now finding their way into sales and earnings, for which we’re grateful. If George were still here, I’d point that out to him with some significant vigor.

Doug Harned - Sanford Bernstein

Well, great. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Myles Walton from Oppenheimer; please proceed.

Myles Walton – Oppenheimer

Thanks, good morning, and good quarter Nick. Apologize if you did say it, but can you provide the expectation for full year volume and margins at Gulfstream?

Nick Chabraja

I don’t even want to guess right now. I think it’s consistent with the guidance we gave you earlier. I think this is too tough. We’re going to work it, so that we get enough EBIT to make the guidance that was implicit the last time around that we talked about that, but what the volume will actually be is too hard. For example, in the quarter, we didn’t have one pre-owned sale.

I don’t know what kind of guesstimate I have to make here for you and the margins are so variable depending on what’s in and what’s out, but they’re working around an EBIT that looks like $650 million at Gulfstream, and I believe that they will come very close to that. Beyond that, I don’t really have anything to say.

Myles Walton – Oppenheimer

Can I squeeze in one, which is the cancellations in the quarter; what was the dollar level of the cancellations? I think the book-to-bill you quoted was probably gross book-to-bill; is that right?

Nick Chabraja

Book-to-bill is all orders in the quarter, less deliveries. So I don’t know the total dollar volume; I haven’t parsed that. Somebody probably knows it, but I don’t know that, that’s not a metric that’s interesting to me.

You used the word cancellation, we didn’t have any cancellations, we had some defaults, and those defaults were covered either through securing another buyer and the delta made up with uniform commercial code cover damages or in some other fashion, but we haven’t permitted cancellation of any of our contracts. We’ve renegotiated some, but cancellation is a term that’s foreign to our vernacular.

We went through this in 2002, 2003. As a result, we’ve been significantly more disciplined about our contract activity, and part of the reason that I’m feeling some stability in that backlog is our good customers have found out what those terms and conditions mean and that they’re bound by them.

Operator

Your next question comes from the line of Joe Nadol from JP Morgan; please proceed.

Joe Nadol - JP Morgan

Thanks, good afternoon Nick. My question is over at Marine, you came to a deal with the Pentagon on DDG-1000 and some swaps. I’m wondering if you could comment on the swap and particularly on the report that you accepted a fixed price contract on the second DDG-1000.

Nick Chabraja

The so-called swap, I don’t know if that’s an appropriate name for it. There’s a realignment requested by the Pentagon, by the Department of Defense, Department of Navy, with respect to the DDG-1000.

They preferred that all three of those boats be built at the Bath Iron Works and there was in addition, three additional DDG-51s that were identified, one in fiscal year 2010 and two in FY ’11; two of those to go to Northrup Grumman Ship Systems and one to Bath Iron Works. That is the broad outline of the so-called swap.

Now, with respect to contracting activity, Bath Iron Works has the first DDG-1000 under contract on a cost plus basis. We have expressed a willingness, in response to an inquiry of the Department of the Navy, to enter in to fixed price contracts on the second and third boat; they have not done so.

Joe Nadol - JP Morgan

Sorry to interrupt, but can you speak to your willingness to get into fixed price, given the history of fixed price contracts in shipbuilding, which we’re all very familiar with?

Nick Chabraja

In my history, that’s the only way to make money. We did spectacularly on the product carrier. We’ve done okay on TAKE-1. This is the most mature design we’ve ever been asked to build, ever, including the Virginia class. This is a complete design.

We’ve tested that design by building modules. We’re comfortable with it and we’re comfortable with our estimating ability. I’m not as comfortable that the parties will reach agreement, but we’re willing to do it, just as we were willing to do it on the secondary combat ship and we couldn’t come to an agreement the first time through. We will, I think this time, but its part of the risk of being a ship builder, and it’s a risk that I feel very comfortable with here.

I sat through the red team reviews of the estimating, together with Mike Toner. We had this done across the entirety of the group, with a lot of good give and take and I feel very comfortable that this is not a parametric analysis that our ship builders have done, but it’s an analysis based on the existing design, their work and the work we’ve done in the shipyard to prepare ourselves for these ships. So if we can come to agreement on price, we’ll do it. If we can’t, we won’t.

Joe Nadol - JP Morgan

Okay. Nick, on another note, is this our last earnings call with you or do you plan to participate in July and going forward?

Nick Chabraja

This to my regret is my swan song Joe, thanks for asking.

Joe Nadol - JP Morgan

Well, it’s been wonderful over the years working with you and to think we’ve had 40 something calls with you, so thanks for everything.

Nick Chabraja

Thank you. Thanks for the memories. I’ve been doing this with you guys I think for 12 years, maybe 13; I did it a little bit when I was Executive Vice President. Jay and Hugh will have the great privilege of carrying on our tradition of discussions, but thanks a lot; I’ve enjoyed it a lot.

Operator

Your next question comes from the line of Robert Stallard from Macquarie; please proceed.

Robert Stallard – Macquarie

Good afternoon.

Nick Chabraja

Hi Rob, how are you?

Robert Stallard – Macquarie

Great thanks, and you?

Nick Chabraja

Good.

Robert Stallard – Macquarie

I’d like the to echo Joe’s comments as well; we’ll miss you, Nick. As we put all your comments together regarding the divisions and the performance you put up for Q1, how do you feel about your EPS guidance that you issued of $6 or $6.10 for this year?

Nick Chabraja

Look Rob, I think we’re clearly not backing off that guidance. I saw in some of the commentary that people might have been expecting lower guidance, we’re clearly not, and I think I’ve painted a picture where there’s some upside potential.

If we asked ourselves the questions that are out there, I think they’ve been asked in part. What are the drivers? Will the Marine group volume hold up at the kind of growth that they enjoyed this quarter? Are we looking at a volume that’s four times this quarter’s revenue? So their operating earnings will be up and that’s a more important driver to them, than whether or not they can eke out another 20 basis points of margin.

On the IS&T side, same question; will the growth hold up through the year and will they be able to outperform on the margin guidance I’ve given you? They’re ahead of it now by about 30 basis points. Here operating margin is more important, because of the size of the base. When you’re talking about a business that’s well in excess of $10 billion, starting to get 30 or 40 basis points makes a big difference.

Combat systems, I think the volume is there. The issue there is will they make the 12.5% margins that we guided you to, given that they’re down in the quarter about 11.6, but remember on that question, I guided you to about 110 basis points lower than last year’s average and if you apply that 110 basis point discount across each of last year’s four quarters, you would have come out this quarter about 11.9.

So that tells me we’re kind of tracking, but a little bit below where I’d like to see it and I’ve got a couple of belly buttons where I could touch and feel it, that I talked to you about. One was the MRAP, that didn’t sustain itself after the early quarters last year, and the other was a little bit weak performance in Europe in the quarter that I expect to rally, but those are the big moving pieces.

I think Gulfstream is going to come out okay. I think they’re going to do pretty much what they promised on the replant, once we shrunk the production planning and I have a high degree of confidence that we’ll produce and deliver the 73 large Gulfstreams that we put in that replay. I think the financial metrics look okay. Maybe we can get a little juice out of this and we can beat a little more money out of jet aviation, but I think those are the moving parts.

So they could permit someone to forecast more, but I’m not prepared to do that right now and Jay may get the opportunity to speak to this into the second quarter, which is sort of when we traditionally give you a lets see if we have an update.

Robert Stallard – Macquarie

That’s great. Thanks so much Nick.

Amy Gilliland

I think we have time for one more question.

Operator

Your last question comes from the line of Robert Spingarn from Credit Suisse; please proceed.

Robert Spingarn - Credit Suisse

Well Nick, it’s been a lot of fun, but before you go, perhaps a question on cash flow and this may be for you or for Hugh actually, I’m not sure. You alluded to the weakness in the quarter and the seasonal recovery we should expect, but perhaps you can speak specifically to the very weak advances and the mechanics of how that flows through Gulfstream and I think you mentioned jet as well.

While talking about that, maybe you could talk about these default transactions and the mechanics of how those work, where I suspect the customer that moves in pays a highly discounted price, offset by the deposit forfeited by the other customer.

Nick Chabraja

Let’s talk first about cash. Gulfstream and jet were both users of cash for somewhat different reasons. In jet’s case, it was the operations, not meeting operational milestones that enabled them to collect cash on major projects; so operational improvement and just ordinary performance timing issue for them in getting to the milestones and collecting the money.

In Gulfstream’s case, it’s a highly complicated pattern, in part working off cash advances, in part returning cash to customers who forfeited liquidated damages. So we collected some $30 million in liquidated damages under contracts in the quarter, and I don’t know how much we returned to those very same people, but it was considerable.

Some of our contracts call for liquidated damages as opposed to a cover remedy. Those are typically contracts further out. You asked about a UCC cover remedy; if you are in default, it is my obligation or the Gulfstream’s obligation to mitigate your damages, which they do by finding a buyer.

In most instances, the customer approves the price that we sell it at. We don’t have to seek their approval, but we have to be able to demonstrate that we made a good faith effort to mitigate their damages, and that we got them the best price we could in that spot market environment.

In most instances, these customers have been satisfied with the effort we made and have agreed with us that the price that we sold their position for was satisfactory and when the transaction closed, we returned their money, apart from the cover remedy itself, the damages.

Robert Spingarn - Credit Suisse

So they absorbed some difference between the new price and the original price?

Nick Chabraja

That’s exactly right. It’s called cover.

Robert Spingarn - Credit Suisse

And should we conclude then, that these buyers that are moving forward, are finding these newer prices competitive with what these heavily discounted aircrafts looked like on the secondary market because as you mentioned, you noted…

Nick Chabraja

Bob, I have no idea what they think or what they do, but they’ve stepped up with money.

Robert Spingarn - Credit Suisse

One would have to think it’s not too different a number for that to have happened.

Nick Chabraja

Why speculate about it? I mean, they did it.

Robert Spingarn - Credit Suisse

The advances being as negative as they were, this is mostly progress payments, not deposits associated with the newer orders?

Nick Chabraja

It’s working off progress payments that we have received, not having an order activity that refreshes that advanced payment, some slippage in progress payments. I mean it’s a build-up of seven aircraft and three of them that are sitting in pre-owned inventory instead of in cash. So a lot of different chunks of this, but we expect it to cure.

Robert Spingarn - Credit Suisse

Okay. Thanks Nick.

Operator

At this time, this concludes our Q-and-A session for today. I would now like to turn the call back over to Amy Gilliland for closing remarks.

Amy Gilliland

I want to thank you for joining the call today and if you have additional questions, I can be reached at 703-876-3748. Have a great day.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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