General Dynamics Corporation (GD) Q1 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the first quarter 2012 General Dynamics Earnings Conference Call. My name is Jeff, and I'll 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 conference over to your host for today, Ms. Amy Gilliland, Staff Vice President of Investor Relations. And you have the floor, ma'am.

Thank you, Jeff, and good morning, everyone. Welcome to the General Dynamics First 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. And with that, I'd like to turn the call over to our Chairman and Chief Executive Officer, Jay Johnson.

Thank you, Amy, and good morning, everyone. Let me start by noting that today mark the 60th anniversary of General Dynamics' listing on the New York Stock Exchange. Generations of employees have helped to make this great corporation successful over the past 6 decades. Our exceptional people continues to drive GD through their innovation, operational excellence and commitment to continuous improvement. I am proud to be their CEO. Before speaking to the quarter, I want to address the current defense budget environment. On the fourth quarter call in January, I mentioned the potential for complications to 2012 budget execution from the combination of upcoming elections, the likelihood of another continuing resolution and the threat of sequestration. These potential complications have indeed revealed themselves to us in the first quarter, particularly in our shorter cycle IS&T business, as looming budget cuts negatively influenced Department of Defense and federal government acquisition execution. While it's still early in the year, we're in no position to know the full effect of these complications on the year. The anxiety over these issues will almost certainly escalate, as we move into the summer months and the election campaigns roll into high gear. Washingtonians are seemingly unified in their belief that sequestration will not happen as currently legislated, although no one can explain how avoiding the severe cut will be achieved. In recent weeks, Pentagon leadership has reiterated that no plans are in place to deal with sequestration, while stating that they expect further guidance from the Office of Management and Budget this summer on how to begin planning. This will certainly spawn increased rhetoric and speculation, as details emerge on how cuts will be administered, making it even more difficult to overcome our customers' reticence to commit resource. In the midst of this uncertainty or the…

Thanks, Jay, and good morning. Before we start the question-and-answer period, I'd like to cover a few additional financial items, including some more detailed discussion of the $67 million adjustment in the Combat Systems segment. And let me start there. This adjustment is the result of human error, which we've caught and have now corrected. We have accounting policies and procedures and systems in place throughout all our operations. Unfortunately, sometimes, individuals fail to follow them. I should mention that this was limited to and isolated in our European-Land-Systems-based -- Switzerland-based vehicle business. Beginning in late 2010 and spread over every quarter in the interim, there were 2 central accounting issues. I want to remind everyone that they were accounting issues, not performance issues. First, revenue was recognized in excess of the contract value on 3 contracts due to foreign exchange costs that were improperly accounted for. And second, revenue was recognized on costs that were not properly recorded to cost of sales, but rather, remained in CIP. We have evaluated this adjustment, the quantitative and the qualitative impact of the adjustment on the current quarter, prior quarters and the full year earnings, and we've determined that it was not material. Moving on to net interest expense, net interest expense for the quarter was $39 million versus $34 million in 2011. For 2012 we expect net interest expense to be at the lower end of our range of $155 million to $160 million. At the end of the quarter, we had just over $900 million of net debt, down just over $100 million from year-end. The effective tax rate was 31.3% for the quarter compared with 31% in the first quarter of 2011. For the full year, the effective tax rate should approximate 32%, rising slightly over 2011 due primarily to the lack of an extension of the R&D tax credit. We plan to contribute $500 million to our pension plans in 2012. Funding will be the greatest in the second and third quarter, the first installment of approximately $100 million having been made in early April. Finally, now that we've seen one quarter of run rate, we are lowering our forecast of corporate expense, which is shown in the segment detail of operating earnings in Exhibit B to the press release. We're revising that forecast to $70 million down from the $80 million we were forecasting at the beginning of the year. Amy, that concludes my remarks, and I'll turn the time back over to you for the questions and answers.

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

[Operator Instructions] Our first question comes from the line of Robert Spingarn with Crédit Suisse. Robert Spingarn - Crédit Suisse AG, Research Division: Jay, could you talk a little bit more about the sensitivity at IS&T? You've adjusted the guidance given the pressure. How do we think about a CR in the fourth quarter might -- how that might further affect things?

First of all, as I think we've probably talked before, we see the likelihood of a CR very high. So I think that will be the reality we deal with later in the year. But I will say that we've had a slow start as I described in IS&T, but we are starting to see award activity. My guidance assumes the resumption of my terms here, what I would call more normal activity as the rest of the year progresses. We have indications that, that is still going to be the case. The encryption business, as I described, will have to move here at a certain time, because you just can't put that off, but so long. So that was the basis of my timing statement. The communications programs, specifically WIN-T and JTRS, are in the test at NIE next month, and we expect LRIP-II decisions that are in the plan. We have every indication that's going to happen here, May, June timeframe or slightly thereafter. That's 6,000 Riflemen radios and more Manpacks. So we feel pretty confident that, that's going to happen. So what am I saying? I'm saying then that we see enough daylight ahead of us, even in front of the fog bank, and feel that a CR at the end of the year, based on what we have already appropriated, if you will, in 2012, will put us in pretty good shape just to go through that fog bank with the guidance I've just delivered. Okay? Robert Spingarn - Crédit Suisse AG, Research Division: Yes. Would you characterize IS&T as having greater uncertainty than Combat at this point?

I think, yes, of course. And why do I say that? Because, again, it's the shorter-cycle business, and it's been the one that's been, shall we say, most exposed here. Through the CRs -- look at it this way. I don't want to over-dramatize here and say perfect storm scenario, but in a way, you could almost make that case when you say, "Look, we've had 2 CRs in the last year. We're likely to have another one. We've got the reality of award delays." We got -- because of that or part of that is protracted acquisition cycles. You got this fog bank as sequestration out there. And then we've got programs that were mature and very successful concluding Pentagon [ph] renovation, Rescue 21, CHS-3, the Walter Reed here in DC. So that being replaced by other programs -- these are good programs, but they are slow to pick up the ramp, if you will, and the margins will probably be a little challenge relative to the old mature programs until they get rolling. But still in all, that scenario, I can see it through what appropriated in 2012 in a way that makes us confident that the guidance is very achievable. Could it change? Sure it could change, but right now, the best vision we have says, we think we can get there.

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

Actually, I wanted to put a finer point on the other question. I guess, as we -- can you just help us reconcile a little bit, Jay, sort of what seems to be conflicting puts and takes between you're talking about budget cuts affecting execution and anxiety escalating? And then revenues and margins in IS&T being back half-weighted and award activity improving. And I'd also love if you could touch on top of that. Talk to us about what's happening with award fees in general. Where are you today versus a year ago and versus maybe 2 or 3 years ago?

Okay. Let see, Heidi. We do believe that it's going to be back-half-weighted. I mean, one of the reasons I took the guidance down was because of what we're seeing so far. So if you take my guidance down 5% as I just did, and then you look at the rest of the year as I just described to Rob, is there uncertainty out there? You bet you. But again, if the appropriated funds are obligated, we believe this is a good piece of guidance for IS&T. As we've discussed and will continue to discuss, I'm sure as the year goes on, the fog bank becomes more real the closer we get to it. But again, I was -- to be very honest with you, 3 weeks ago, I was more concerned about it, it being 2012 execution, than I am today just because we are starting to see some award activity that was frankly absent in the first part in the majority of the first quarter. So am I enthused about that? I'm gratified by it, and I'm hopeful for it, but you know, the check's in the mail to a certain extent here until we see, as I mentioned before, more sustained "normal activity" going forward. And that ties back to the obligation of appropriated fund. So it's going to be a very, I think, dynamic is probably a fair way to say it, year, particularly in the shorter cycle IS&T business. But I'm giving you the straightest we have right now on the view that we see out forward. The award fees in general, and that I don't see frankly -- I guess, the comment I would make would be the competition you see, in particularly, the IT Service business is as intense or more intense than it's ever been. So there, I think, Heidi, is where you're seeing a lot of that. That accounted for -- the IT Service business is probably about 1/3 of the decline in my forecast. The Tac Communications business was probably 50% to 60% of that decline, and part of that decline in IT service frankly is biz lost, my term, in this hypercompetitive environment which gets to your point on these.

Just one last follow-up. Jay, when we -- you sort of -- I guess, when you talk about the 5% guidance down and obviously, we wonder whether that's sufficient, can we at least have the understanding that you've baked enough cushion in the other divisions that could have potential offset to what we're seeing or potential worsening in IS&T?

Yes. I think -- I mean, my answer to that, Heidi, is yes. And if you look at -- I see opportunity, and I've used a little of guidance in Aerospace and Marine, in both. And I'm very -- at this point, I feel good, confident about Combat Systems, in terms of absorbing the impact of what happened with the accounting issue at ELS. But the 3 U.S. businesses were essentially on and on. So I think yes. That's a long yes to your answer.

Our next question comes from the line of David Strauss with UBS.

Jay, back on IS&T, you talked about service being a bigger portion now and that impacting the margins. Can you give us a break out of service versus product? And given the bigger portion at service now, or normalized margins when IS&T kind of get back to somewhat normal here? Or are normal margin's going to be more in the 9% range on a go-forward basis?

9% to 10% is probably -- what I have in my head right now is a fair answer. To your earlier point. Were talking, right? Given the, shall we say, pullback or delay in the tactical communication and the product business in IS&T, the service side of it takes 40%, 45%. It becomes -- you're approaching half of the IS&T book is in the Service business with great business, as I said in my remarks, great return on the investment, but at a lower margin.

And then in Gulfstream, you commented that North America was pretty strong. Can you give us a break out how much North America, actually -- how much of total orders were North America in the quarter?

For the quarter, it's about 60%, so -- and I've talked about that some in the past, but I think it's really good for everybody to see that coming back. And even better, when you match that to the other statement I made, which is if not North America replacing Rest of World, Rest of World is still doing great, but North America is also coming back now, which is, I say, a good sign for everybody.

Our next question comes from the line of Robert Stallard with Royal Bank of Canada.

Jay, on the Aerospace division, I was wondering if you could comment on the pricing situation in the quarter, whether you've seen any improvement there, and how it differed from model to model and even region to region.

Pricing did you say?

Yes.

Okay. Right now, the pricing is very strong on the large cabin. That's a consistent statement. That hasn't changed. And frankly, I don't see it changing, both 450 and 550 for us. The mid-cabin market as we see it, based on the activity levels and listening and talking to the other OEMs, I think for us, it's improving, but still a bit challenged, I guess, is a fair way to say it. We're seeing 280 activity. The 150 activity for us was slow in the early part of the quarter, and it picked up in the latter part of the quarter. So that's a good thing. I hope that's responsive to your question.

Yes, and just a follow-up. With the strong pricing and the continued strength in the backlog for the 450 and the 550, what point, do you think, can we anticipate production heading higher?

We've got a pretty good chance of having it about right now, because as I mentioned, we're still in kind of a 18- to 24-month sweet spot backlog. And as long as that's the case, I think we've got the production rate about right.

Our next question comes from the line of Doug Harned with Sanford Bernstein. Finbar T. Sheehy - Sanford C. Bernstein & Co., LLC., Research Division: It's been Finbar Sheehy for Doug. As you mentioned earlier, in Washington, there seems to be a broad agreement that sequestration would be bad, but no clear path to avoid it. At what point during the year do you need to have contingency plans in place, just in case they actually don't manage to avoid it? And how do you think about what sort of actions you could take, especially given the sequestration, if it ever happens, could be quite short lived or not?

Yes. That's a tough one to give a crisp answer to, because we don't know the frame of the template that we're going to be dealing with. Suffice it to say that as I've said previously here, I think the challenge for us, the responsibility, really, for all of us, is to stay committed to executing the appropriations that have been laid forth for the year. And if we can continue to do that, there's reasonable news in entering as I say, that fog-bank-called sequestration out there. How it manifests itself, nobody knows. How do you prepare for that? It's really tough. But what you do is you maintain your agility, you keep running your business, you control your costs as best you can, you stay focused on execution, and you don't overcommit yourself with capital, I think, in that kind of an environment. And that's about the best protection I believe you could give yourself coming into something that is unknown as what we're seeing right now. Finbar T. Sheehy - Sanford C. Bernstein & Co., LLC., Research Division: And just a quick follow-up on a specific aspect. You mentioned about restructuring in European Land Systems. Can you give us a sense for the scope and scale of that? Sort of how far you are along in it? And whether the restructuring costs might be a drag on margins this year?

No, to your latter. And it's been a work in progress quite honestly for quite some time. Example would be the movement which we executed late last year of the ELS headquarters from Vienna to Madrid. So we're attending to that, basically all around. And it's continuous work. And it'll continue to occur as we move forward, but it's not impacting our margins right now.

Our next question comes from the line of Sam Pearlstein with Wells Fargo.

Jay, I guess, I want to take a different tack, which is -- that if I look at your guidance and I see Marine margins up, Aerospace up, even with the volume cut at IS&T, you mentioned interest expense in the lower end and corporate expense in the lower end, it would seem as though, actually, you should be higher, not at the low-end. And so I'm just trying -- are you forecasting a contingency of a continuing resolution? Is it haircutting, that IS&T could be worse? Where are you hedging? Because it would seem like it actually should point higher, not lower.

Yes, I appreciate that, Sam. And I would just tell you that I think particularly, as it applies in IS&T, we like what we're seeing. We just haven't seen enough of it. That's a fair way to say it. I mean, it's early in the year. There's starting to be movement. We're starting to obligate the appropriated funds. We're starting to see that. That's a good thing. If that continues, okay. Then maybe I can feel differently. But right now, in terms of where within the $7.10 to $7.20 band we are, but right now to be honest with you, I haven't seen enough of that goodness, and I've got the $0.13 dividend. That just was the reality here in the first quarter. That's what puts me at the low-end. I'd love to outperform that. And I'm hopeful that we can. But I'm just not ready to write that check yet.

Okay. And then just secondly, it sounded like when you mentioned the 650 and 280 type certification that it perhaps it flips into third quarter. What's happened there? It just seems like it's moved a little bit to the right.

Yes, it has -- I mean, to be fair. And it's frankly just a matter of scheduling and executing a very detailed test regimen with our partners in the FAA. I mean, that's pure and simple. And may we do it better than that, yes. But right now, with the testing, we see that they want to have -- I'm just -- I'm hedging it a little bit. I'm not worried about it. It's just a matter of -- and it's not just a matter of getting type certification, okay. You get type certification, then you have to get the simulators certified, then you have to get the crews for the airplanes that are entering into service type rated, et cetera, et cetera. So it's a fairly complex set of realities you have to be dealt with, starting, of course, with getting the type certification. So if it happens, second quarter or third quarter, to me, I'm happy either way it's coming, the airplanes are performing beautifully and there's great enthusiasm for them out there. So I'm not hedging it, because I see a problem. I'm just hedging it because of the reality of the testing and the pacing of that testing. This isn't the only thing the FAA has to do either. So I'm just being sensitive to that.

Our next question comes from the line of George Shapiro with Shapiro Research.

42, LLC: Jay, on that score with the G650, have they done the test that caused the problem, that caused the crash last year?

Yes, we've done those, yes. I mean, we've done most, all of the, as I would characterize it, company testing. But the protocols are such that you do it, and then you analyze it, and then the FAA works with you, and you do it again. So it's a series of sequential events that have to occur here. And so that's I think the answer that you were looking for.

42, LLC: And then a quick follow-up, were forfeitures at Aero around $20 million? And is the jet completion business still have a loss this quarter?

Sorry, I missed the first part of that, George.

42, LLC: Were the forfeitures at Aero about $20 million from the G650 cancellations?

I don't quantify that. But I've been very consistent here in saying that we expected a number of G650 cancellations once the PPC call was made. And we got basically what we expected. So Gulfstream piece of that is in line. The reason I brought up the other for the Aerospace and backlog is because it was a big jet that fell out of the backlog, because of, frankly, the death of a customer.

42, LLC: And did the completions business have a loss yet in the first quarter?

No, completions business is doing -- is on plan. And I'll take the opportunity to say that you didn't ask this, but I mentioned, we've delivered 1 of the 3 aircraft. I would tell you that the -- just to reaffirm to everybody and to my folks at Jet that the feedback I'm getting first hand on the quality of those airplanes, and what they've done is spectacular.

Our next question comes from the line of Jason Gursky with Citigroup.

Just a quick follow-up on Jet Aviation. You talked about the deliveries of some of the challenged planes going forward. Can you just talk a little bit more in detail around the timing and the margin recovery of Jet? Just kind of update us on where we are? And when you think that Jet will reach normalized margin rates? And what more do you need to get that done?

Well, as I said, Jason, I think before that what I expect out of Jet this year is essentially breakeven, and then we ramp from there. And right now, I feel pretty good about that. In fact, I feel very good about that. The real challenge in the completions business, quite honestly, will no longer be our ability to manage the throughput. It's to fill the skyline. So what am I saying? I'm saying if the business is out there, we've got the protocols and processes in place now to really nail that business, okay, which is good news for everybody. I'm really proud of what they're doing now. And the challenge will be if the customer demand is there. And we're working on that very seriously, as you would expect.

Our next question comes from the line of Carter Copeland with Barclays Capital.

Just a quick one on Jet, on the wide-body cancellation. Was there any P&L impact as a result of that in the quarter? Or was it just the backlog?

Mostly backlog. Maybe just a smidgen on the quarter. To be honest with you, I can't -- I don't even have the number in my head, but it's not material. It's mostly just backlog, Carter.

I just didn't know if there was a big forfeiture, I mean, in one time. And secondly, I know there's a lot of discussion on The Hill about Abrams and the facility and the budgeting there. I wondered if you might provide us an update with how you see that playing out, and what risk there may be in the guidance, should you not see the sort of plus up, you guys were trying to get similar to last year.

Yes, I mean, I think I'm not worried about the 2012 piece. We've got work to do as I mentioned before in 2013. But I would say that it's pretty consistent here, in terms of the concern -- that Abrams has generated with JSMC Lima regarding the whole issue of defense industrial base going forward. And we've had, as recently as yesterday I think, I read in the clips this morning, 170 members of Congress signed a letter to Secretary Panetta expressing their concern on this issue, which says, frankly, this defense industrial base, as we go into this full fog bank and deal with the new realities that everybody's challenged with, the defense industrial base is elemental to that discussion. So from our standpoint, of course, we think that totally appropriate and must be part of the calculus, and we're very encouraged by it.

Our next question comes from the line of Joe Nadol with JPMorgan. Joseph Nadol - JP Morgan Chase & Co, Research Division: You had some pretty significant management announcements over the last several weeks. And Jay, I'm wondering if you might comment on a, on how you and Phebe will be working together in her new role. How do you envision this role? And any update you can provide, given this announcement, on succession plans for the company? And also any comments you might have on the new head of your Shipholding business?

You're not trying to push me out the door, are you, Joe? Joseph Nadol - JP Morgan Chase & Co, Research Division: Not at all. Just want to get the updates, pretty big announcement.

Now, listen, first of all, just to refresh, next week, the 2nd of May, to be precise, Phebe Novakovic does become the President and COO, working directly for me. As you would expect, that's the start of a very disciplined succession rhythm here, if you will. She and I are spending a lot of time together as you would hope. And I'm very anxious to get started here, frankly. We spent a lot of time with my direct reports now, executive vice presidents, senior vice presidents with Phebe. And so the transition is beginning, and we're very encouraged by all of that, so -- and we'll continue to work very closely together as you would hope. Likewise, Phoebe is in the process as we speak of turning over Marine Systems group to John Casey, who is currently President of Electric Boat. And then John will be turning over EB to Kevin Poitras, as you probably know. In every one of those moves, we're very well served. And John's going to do a superb job as EVP, and Kevin will do likewise as the President of Electric Boat. So it reaffirms, frankly, the bench strength of General Dynamics and how seriously we take the succession business. And we feel very comfortable with all of that, Joe. Joseph Nadol - JP Morgan Chase & Co, Research Division: Okay, Are there any comments you can make on just how you and Phebe will be working together day-to-day on running the company? Are you going to maintain a focus on different areas than her? Or are you going to make joint decisions? Or how do we think about how you're going to divide the executive responsibilities?

Well, one of the things she'll be doing, first-order, of course, as you would expect, is spending a lot of time with the other executive vice presidents, if you will, and the businesses, getting herself, shall we say, refamiliarized, because she's fairly been total focused in the Marine group as was her task -- to get her now snapped in, if you will, resnapped in to the other 3 business groups. So as first order business that would be elemental to what she's doing. And she and I will work very closely throughout all of that as will the rest of the leadership team. So this is teamwork underlying.

And Jeff, I think we have time for one more question this morning.

Our final question comes from the line of Cai Von Rumohr with Cowen and Company.

So you had very strong large biz jet deliveries in the first quarter. Could you comment, what are you looking for, for the year? Is there upside, given that's very strong first quarter, unless it was bloated by huge forfeitures, which you're seeming suggesting isn't the case, isn't 15.5% a conservative number?

Yes, I always give you conservative numbers, Cai. But, I mean, it's a pretty reasonable number from what I see today. Is there some upside to it? I certainly hope so and I think there probably is. But I think that's reasonable today, quite honestly.

I mean, you haven't told us. I mean, are you looking for more large biz jet deliveries? You said that completions were on plan, but you didn't say whether it was in -- jet was in the black. You say you expect it to only breakeven for the year, so a little hard to kind of see the rollout from here.

I think the completions -- the production rate, as I think I always say, can be -- it's unchanged today. Can it be tweaked a little bit? Yes, as we go through the year. Will it be? It's too early to tell. That's a fair answer.

Thank you for joining our call today. If you have additional questions, I can be reached at (703) 876-3748. Have a great day.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.