Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Phebe N. Novakovic - Chairman and Chief Executive Officer

Analysts

Myles A. Walton - Deutsche Bank AG, Research Division

General Dynamics Corporation (GD) DbAccess Global Industrials and Basic Materials Conference June 13, 2013 11:40 AM ET

Myles A. Walton - Deutsche Bank AG, Research Division

Great. I think we'll go ahead and get started. Those on the webcast and to those in the room, next up, we have General Dynamics. And with -- from the company, we have Phebe Novakovic, the company's CEO. And very much pleasure to have her here. I think this is one of her first conferences, participating in that role she took over in January. So excited to hear about how you're looking at the business, what you've seen thus far, the things that are making you most excited about the opportunities, some of the challenges that you're seeing and dealing with from the Defense business and product development, maybe on the commercial side. It's going to be a freewheeling type of discussion. More than welcome, though, to have audience participation. So if you have questions, go ahead and raise your hand. There will be microphones that we'll pass along.

I think you had these forward-looking risks.

Phebe N. Novakovic

The normal statements with respect to forward-looking statements apply.

Question-and-Answer Session

Myles A. Walton - Deutsche Bank AG, Research Division

So, Phebe, you've now been on the job less -- a little less than 6 months. But you've had perspective on the company for quite a bit longer than that. Can you give us some sense as to what you've seen thus far in the role that again makes you most excited about opportunities that are yet unhatched? And then also, delve a little bit into how you might be changing the processes that you talked about in that January call in terms of the things you identified previously, maybe not working, that you'd like to improve?

Phebe N. Novakovic

I think the best way to start is to walk through each of the business groups and give you an overview of how each stack up. With respect to IS&T, IS&T is on the mend. The precipitous decline in tactical radio seems to be behind us. And on a going forward basis, it looks like we've got revenue that's both sustainable and stable. Margins in the group are improving, our order. Our win rate is improving. And with respect to our IT business, they are getting revenue and earnings team in a very tough competitive environment. Combat Systems is performing admirably with margins in the low teens, good cash flow. They are behaving as you would expect them to behave as a good cyclical. That's expanding margin, managing for cash and reducing cost at a faster rate than revenues decline. Aerospace is off to a good start. Gulfstream has remedies that this equilibrium we talked about in prior calls between the green aircraft and outfitted aircraft on the 650. Jet has stabilized its operations and has been increasing its marketing efforts to bring in new revenue. Margins for the year will likely be a touch lumpy, good in the first half, a little softer in the third and then increasing on the fourth. That's kind of an overview of where we are at this juncture with respect to each of the 4 groups.

Myles A. Walton - Deutsche Bank AG, Research Division

And then maybe the Marine in terms of...

Phebe N. Novakovic

Marine, yes, the group of which I was EVP of. Marine is getting cyclical with earnings and cash, with a growing backlog. We ended the year last year about $17 billion in backlog. We've already increased it through the first half of this year. And that's before we dropped in the backlog any of the multi-year orders that are on the horizon. Very, very steady, predictable performance in Marine.

Myles A. Walton - Deutsche Bank AG, Research Division

Let's go back to Aero for a second. So you mentioned good margin performance first half, lumpy in the third quarter, back to growth in the fourth quarter. What are the dynamics that are pushing that around?

Phebe N. Novakovic

When we talk about margins in Gulfstream, I think it's important to think in terms of mix. Gulfstream is transitioning from almost exclusively a mature series of airplanes with very high margins to a larger mix of new planes that enlisted the 650 and the 280 that initially have lower margins. And that mix between emerging and mature product line is exacerbated in this -- the remainder of the year by some renegotiation of contracts with some of our suppliers on the 450, 550, which will cause some margin compression in the third quarter and then getting better in the fourth quarter as we improve on the 650 and 280 line.

Myles A. Walton - Deutsche Bank AG, Research Division

Got it, okay. And then with respect to Jet Aviation, continuing our focus on the Aerospace for a moment, so that business acquired, summer of 2008, I believe, when things were going quite well in Aerospace, had to deal with a lot of completion work going away, has since been kind of been working on itself for the better part of few years and sounds like it's turned the corner. Can you give us some sense of what the profitability of the business is and then where the business can go from a profit contribution perspective?

Phebe N. Novakovic

The underlying operations are fixed to jet. So as I mentioned earlier, this is really about bringing in additional completions revenue. Jet has -- the value proposition around jet is how well we can do these large-scale completions. Part of the problem was that we failed to integrate that business and we own that. We fixed it, and so going forward, it's simply a revenue play.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. And then as you look at the 650 as a new product and you talked about the imbalance in terms of the completions versus the production, you're now through that -- is that the post-certification rework in the first teams of aircraft that you had to get through and that's now behind us?

Phebe N. Novakovic

There's about 30 aircraft and what we call the retrofit, which was fixing the completions process, adjusting to the FFA certification requirement in a not particularly efficient way. We're through that. And now we, on a going forward basis, we match up our green production with our completions.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. So taking the discussion up to maybe a 50,000 foot view, you're looking at the portfolio which has got the Commercial Aerospace on it, it's got the defense side. Within the defense side, it has different cycles. You mentioned the combat is a good cyclical. And it's certainly seen some of those cyclical dynamics of the business. You just came from Marine, really not much of a cyclical, much of a...

Phebe N. Novakovic

Decade.

Myles A. Walton - Deutsche Bank AG, Research Division

Geologic time, yes. So as you look at that business, where do you see opportunities to disaggregate or aggregate those businesses in terms of commonality, manufacturing, commonality of approach and why those businesses make sense together?

Phebe N. Novakovic

Well, I don't know that I'd be looking to disaggregate any particular business. But let's talk about, again, each in turn in a little bit more detail. Combat Systems is behaving as a good cyclical. This is a mature business with a broad portfolio and high operating leverage. And here is why. Combat Systems is an infrastructure-light business. So its earnings are less tied to its revenue than in heavily based infrastructure business. So in other words, we've got more bearable cost than we do fixed cost, which gives us quite a bit of flexibility to adjust to various levels of revenue. At the same time, recall that the preponderance of our manufacturing facilities in Combat are government owned and operated. That gives us a lot of ability to scale accordingly. So if you think about the end of the hot wars, the case for Army recapitalization has not evaporated, simply moved to the right. So revenues will be based both on low rate production and Army sustainment and a mix of international orders. So as we look at that portfolio and we continue to rebalance and drive for margin expansion and cash, the revenue decline will be somewhat offset by the organic growth in revenue in the Marine group. Again, I think that, that's a nice counter-cyclicality within the portfolio. That all makes sense to me to work together and to provide that balance. With respect to the IS&T group, I mentioned that our IT business is doing quite well. Their win rates are higher. And we have margin expansion opportunities in both of our AIS and our tactical comms businesses. We continue to drive costs out in this environment. And there's a fair amount of internal restructuring that all of those businesses are doing. 2013, as I've expressed before, is really the year of operations. So it's a focus on doing what we know, how to do, expand our margin, drive earnings and manage for cash. So that focus is embedded across the entire leadership team, and it's what we're spending this year working on, get back to basics.

Myles A. Walton - Deutsche Bank AG, Research Division

So on a -- where you left off, driving for cash, you're going to be left with a lot of cash and the decisions of what to do with that cash. As you look around the landscape, different companies make these different decisions within the defense complex on what to do with that cash. Some have gone very aggressive toward share repurchase. Some have gone very aggressive towards dividends. There hasn't been a lot of progression towards M&A by the most of the large companies. Of your capital deployment opportunities or preferences, can you give us a sense as to where your current thinking is?

Phebe N. Novakovic

I think I've been pretty clear and I just reiterated that this year, we're focused on operations. I don't have any acquisition opportunities on my horizon. That said, some potential target popped up that was in our core and was very accretive, it doesn't mean we wouldn't go after it. But I have nothing on the horizon at the moment. So given the focus on operations, I think you can anticipate from us that we will deploy the majority, if not all of our free cash flow in 2013 in shareholder-friendly ways, the dividend which is set and share repurchases.

Myles A. Walton - Deutsche Bank AG, Research Division

And so with the ongoing commitment, is there any minimum level of return of capital that you think is the right guide, post target level?

Phebe N. Novakovic

You need to think about our capital deployment in 3 respects: predictable, sustainable and achievable. I don't see the merit for us in using the strength of our balance sheet to provide additional dividend or buy in shares and reduce our strategic flexibility going forward. I think it's an inappropriate use of our free cash flow in an environment where we don't see accretive acquisitions to return that free cash flow in dividends and share repurchase.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. Questions from the audience? Yes?

Unknown Analyst

[indiscernible]

Myles A. Walton - Deutsche Bank AG, Research Division

To follow on to that, does that imply you're looking maintain your credit rating rate where it is, given that it seems much higher relative to your peers? And is that really an insurance policy to the uncertain environment to which you just alluded?

Phebe N. Novakovic

I think having a strong balance sheet and good debt to equity and debt to capital ratios and a good strong debt rating is a nice strategic advantage, particularly with the flexibility to move quickly and easily in an environment, when and if we get that environment that we've got potential acquisitions out there. So I watch that debt rating because I think it deserves our strategic flexibility over time.

Myles A. Walton - Deutsche Bank AG, Research Division

To go back to Gulfstream for a second. In terms of order activity across the business, you've got landscape, it's been pretty mixed. You've got great recovery in profitability, great recovery in the markets, a very mixed recovery in business jets. It sounded like in the last call, non-650, book to bill, larger 450, 550 -- 500, book to bill was over 1 or about 1. Do you see that demand level continuing? And where exactly is the geographic strength coming from at that high end?

Phebe N. Novakovic

For us, I think I don't accept the basis of the predicate. We had a difficulty on the business aviation. And when I look at Gulfstream's utilization, I see some improvement, which is good news for our service business and for aircraft sales. The 650 and 280 are very strong. The 450 and 550 order book is stable. And I like what I see in the funnel, which gives me great confidence that our 2013 build plan is appropriate. So I don't see a great deal of uncertainty in our end of the market.

Myles A. Walton - Deutsche Bank AG, Research Division

And the 450, 550 build plan for '13, is that a build plan that's sustainable over the next couple of years? And also from a product development perspective, you at Gulfstream had been very disciplined about product refreshes and new product replacement cycles, almost on fixed times, which would suggest the 450 is kind of due. How do you manage that product transition from a demand perspective over the next couple of years?

Phebe N. Novakovic

Let me take that in 3 parts. In the last quarter, and now I'm talking about production rates. In the last quarter, 80% of the large cabin were in the 450, 550, which again gives me confidence for '13. We set our production rates for the following year and late fall, December time frame. So I think it would be highly premature for me to speculate. With respect to product development, suffice it to say, we have a very robust research and development program at Gulfstream. When we are prepared already to announce a new airplane or refresh, we will do so in a very disciplined, public forum, when we have a real airplane and not a PowerPoint airplane.

Myles A. Walton - Deutsche Bank AG, Research Division

But the timeline that you -- Gulfstream has used historically is still the timeline that they're using in terms of baseline through refreshes and new products?,

Phebe N. Novakovic

The timelines apply and they are based on -- in part driven by when, how they are indeed placed out and where we are on our various development cycle.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. Maybe transition to that to Combat for a second. The -- you talked about international awards coming in bookings on the Combat side, and you gave us a progress update on where those are in the pipeline. And also is this year's, 2013, revenue dependent on achieving those in short order?

Phebe N. Novakovic

The series of international orders we have anticipated, we still anticipate they have slipped to the right. As they continue to slip, Combat Systems revenues and sales and earnings will be slightly impacted for the year, but with no material -- no impact on GD at large.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. From a Marine perspective, so the multi-year seems to be coming through the system on the 51 and I'm sure the Virginia class is shortly thereafter. As you look out, again, over the next several years, that business, has it got modest growth? And then what's the margin outlook as well?

Phebe N. Novakovic

I believe that you all may have read that the Navy announced a multi-year award to Bath, 4 ships with a 5-ship option, totaling about $3.5 billion, continued to work with the Navy on specific terms and conditions of the contract and we'll drop that in the backlog. That provides a nice visibility of work for Bath Iron Works going forward. And our job there is to perform on that backlog, drive our cost down and further improve our efficiency. Our auxiliary yard, NASSCO, has a nice mix of Navy work. And the commercial Jones Act building owners are back -- shipowners are back into the market. And we've had some nice awards recently with respect to the commercial ship building which gives us than for NASSCO against ability and its workload. The organic growth engine is electrical. We are negotiating the Block IV contract. And if you've seen, watched us in the past, you'll know that -- enough on the Virginia class, you'll know that when we complete the negotiations on this big block contract, the multi-year contract, we tend to drop $18 billion, $17 billion to $18 billion, $19 billion in the backlog. The key there, again, is to perform on that backlog. At the same time, R&D spending on the Ohio replacement class is increasing. So we have very nice organic growth, led primarily by electric boat as we go forward. Think about shipbuilding margins as they tend to be driven in part -- or driven by mixed shift and both mix shift in product, maturity of products, emerging products but also in the type of contracts, so engineering -- a higher volume of engineering work tends to be cost plus with lower margin. Mature ship construction programs are fixed price with margins upsized. So on a net normalized basis, you ought to look for 9% to 10%, 10.5% margin in that business with upside on the construction and the shipbuilding side, the construction side as we improve our learning curve in each one of these platforms.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. We haven't talked yet about the elephant in the room. It took us 20 minutes to talk about sequestration. So where are we with respect to that in terms of the DoD passing along decisions or making decisions and then passing those decisions along to the contracting base?

Phebe N. Novakovic

Let me talk about that in 2 respects. First, 2013. We entered this year with a fair amount of uncertainty about the impact of sequestration and its application across the various budget lines. The passing of a Defense Appropriations Bill alleviated and eliminated almost all of the pressure for '13. Some of the shorter cycle businesses had some revenue shortfall, but most of which have been -- those wells have been refilled as the department executes its 2013 budget. Going forward, we expect for 2014, it's harder to predict with any clarity The bill -- both the Appropriations and Authorization bills are working their way through Congress. And the extent to which sequestration is applied and the flexibility that the department has to apply any potential reduction are really key. The more flexibility the Defense Department has and each of the military services has and how they take this cuts are more rational they decrease in spending will likely be.

Myles A. Walton - Deutsche Bank AG, Research Division

And so from the perspective of the booking rates through the end of the year, that's likely to see that impact for the 2014?

Phebe N. Novakovic

Well, conceivably. Again, in a budget-constrained environment or reduced environment, mature established programs with a record tend to do better than high-risk developmental programs. So to the extent that the department has some discretions in how they apply their reductions, you're likely to see the programs of record doing better and booking rates should be unaffected.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. But in IS&T, where a short cycle business exists today, is it showing up that you can see it?

Phebe N. Novakovic

Not now. And we have a growing backlog in IS&T that will help mitigate any near-term effect of a 2014 sequestration. But again, I think there's a fair amount of uncertainty how the Congress and the administration are going to deal with the application of sequestration. Is there going to be a grand bargain? Your guess is as good as mine.

Myles A. Walton - Deutsche Bank AG, Research Division

So what do you think is the least understood part of the General Dynamics story at this point? It's gone through a few CEOs now in the last 3 or 4 years. It's got a different mix than a lot of the other large companies. Its capital deployment has been less predictable for the last several years. What do you think that the investor base wants to -- or needs to hear that you want to tell them?

Phebe N. Novakovic

Well, I didn't presume to speculate on what the diverse group of investors may think or understand about our business, as I started in my remarks or our discussion, I walked through each of our businesses. I think that the -- understanding the Combat system value proposition is important. I think understanding the variable cost structure of that business and the margin expansion opportunities, even on lower volume, as we continually improve our operations -- and again, this is a very, very disciplined and mature leadership team. It knows how to drive costs out. So I am comfortable with that Combat System story. I like the counter-cyclicality of revenues with respect to the Navy-funded and Army-funded program. And I think you need to think about GD in 2 respects. I'll reiterate that our capital deployment is going to be predictable, steady and achievable. So year after year, you ought to see the same kind of behavior. At the same time, parallel with that, is we're going to get back to the operational excellence and discipline that we know how to do and run our programs and be the lowest-cost, highest-value producer in each one of our market spaces. So I think that consistency, predictability and steadiness and some confidence that the management team is going to address the challenges that any business would face and address them in a shareholder-friendly manner.

Myles A. Walton - Deutsche Bank AG, Research Division

One of the things you mentioned is the cyclicality of Combat and behaving in a good cyclical and managing the costs ahead of revenue declines. So does that imply that this level of margins that we're seeing, which are 400 basis points above where they were 5, 6 years ago is still a sustainable level going forward under the scenarios of a declining environment for Combat?

Phebe N. Novakovic

In my mind, yes. And I think both, because I understand the business and I understand how we're taking costs and our recent performance should underscore the ability of this series of businesses to drive costs out of their business, again, because of the variable cost structure that they've got and the flexibility that they have in adjusting our build rates. And this group will continue to rebalance its portfolio. We'll continue to look for cost-cutting opportunities and margin expansion opportunities. It's important to be a good cyclical in my mind, and it's easy to say and hard to execute. You have to live it every day. You have to drive costs out at every part of your business, every process that you touch. Combat Systems has been doing that, and we'll continue to do it. So this is not a business that's facing any cliff. This is a mature business that is the #1 or #2 in each one of the markets that it's played. So it's -- I like where we are.

Myles A. Walton - Deutsche Bank AG, Research Division

So in Aerospace, you did mid-17% margins in the first quarter. We already talked about kind of sequential lumpiness for 2013. As you look beyond 2013, it sounded like some of the lumpiness was one-time, related to contractual settlements in '13. So is the underlying margin performance at Gulfstream really in the 17.5% range and we should look at that as a baseline to grow on additional volume?

Phebe N. Novakovic

Well, again, margins will be driven by mixed shift. And as we continue to mature and improve, our manufacturing processes and bringing 650 and then completions and we continue to go down the learning curve on the 450 and 550, we have margin upside in the out years. A caveat that against, that we have a very robust R&D and CapEx spend to sustain the business over time at Gulfstream. And -- but I think we haven't fully realized the potential, the ultimate potential. I know we haven't fully realized the ultimate potential of 650.

Myles A. Walton - Deutsche Bank AG, Research Division

Do you see it getting to the 20% that Gulfstream, as a standalone, admittedly now to Aerospace, but Gulfstream as a standalone [indiscernible]?

Phebe N. Novakovic

Well, you can drive high margins by artificially stimulating production rate. That means if you're a one-trick pony and you have only one line of business, you can do that. But for us, we have a portfolio of businesses, and I don't see any value in hyper-inflating the production line, getting a near-term kick in earnings and margin and cash flow and then not being able to sustain it. I go back to sustainable, predictable, achievable.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. Questions in the audience? If you were going to turn the page on M&A in '14 and light the lights to -- not trying to imply they're not on this year, in the strategic planning office, but you light the lights next year, where in the portfolio do you think you have the holes? Or where is it that you'd like to broaden the scale?

Phebe N. Novakovic

I think it is wise stewardship of capital to invest in areas -- in target businesses that are within your core, that you understand the risks and that you're able to manage the risks and you price them accordingly. So I can see some deployment of capital for a potential acquisition to build our core or alternatively in areas where we have a presence, but because of mass, they are not yet core. I could see targeting some acquisitions around both -- those areas. But I think it's a high-risk venture to move into adjacencies and at the so-called fast currents, whatever they are, du jour, I think the ability of the company to understand an adjacency is -- are diminished. And your ability -- increasing your ability to manage and mitigate those risks decrease. So I'm not a big fan of moving into adjacencies. You'll see us continue to add to our portfolio in places where we are the core and where we can take smaller businesses and smaller lines of business, bolt on, some acquisitions to those and build some critical mass to make core. But we're going to stick to our knitting, do what we know how to do. I think that's with the shareholders should expect from us, and that's what we intend to do.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. Any last questions? I guess none. I think we're out of time. Thanks so much.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: General Dynamics' CEO Presents at DbAccess Global Industrials and Basic Materials Conference (Transcript)
This Transcript
All Transcripts