Hello, and welcome to the General Dynamics First Quarter 2022 Conference Call. My name is Alex, and I'll be coordinating the call today. [Operator Instructions]. I will now hand over to your host, Howard Rubel, Vice President of Investor Relations for General Dynamics. Over to you, Howard.

Thank you, operator, and good morning, everyone. Welcome to the General Dynamics First Quarter 2022 Conference Call. 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, 10-Q and 8-K filings. We will also refer to certain non-GAAP financial measures. For additional disclosures about these non-GAAP measures, including reconciliations to comparable GAAP measures, please see the slides that accompany this webcast, which are available on the Investor Relations page of our website, investorrelations.gd.com. With that completed, I would like to turn the call over to our Chairman and Chief Executive Officer, Phebe Novakovic.

Thank you, Howard. Good morning, everyone, and thanks for being with us. As you can discern from our press release, we reported earnings of $2.61 per diluted share on revenue of $9.4 billion, operating earnings of $908 million and net earnings of $730 million. Revenue is flat against the first quarter last year. Operating earnings are down $30 million, but net earnings are up $22 million in line which distorts the truly strong performance of the operating units. The improvement in net earnings was aided by less interest expense and a lower provision for income taxes against the year ago quarter. Earnings per diluted share are up $0.13 or 5.2% year-over-year. The operating margin for the entire company was 9.7%, 30 basis points lower than the year ago quarter. This was as anticipated in our earlier guidance to you, but also shaped by the aforementioned expense at the corporate other line. From a slightly different perspective, we beat consensus by $0.10 per share. We have roughly $400 million more in revenue than anticipated by the sell side and almost $20 million more in operating earnings. We also beat our own expectations, particularly so in aerospace, about which I will have more to say shortly. As we indicated in our press release, cash from operating activities is just shy of $2 billion and about 270% of net income. After capital expenditures, free cash flow was $1.8 billion, 250% of net income. This is particularly impressive following a very strong cash performance in the fourth quarter of last year and not at all typical for us in a first quarter. Obviously, we are off to a good start here. This is particularly impressive following a very strong cash performance in the fourth quarter of last year and not at all typical for…

Thank you, Phebe, and good morning. The first thing I'd like to address is the unusually high corporate operating expense of $71 million in the quarter, which is up from $32 million in the year ago quarter. Given our full year expectation of around $110 million in corporate expense this year, you might have expected a first quarter number similar to last year. However, this year was impacted by a change to some of the terms of our equity compensation plan, which resulted in the acceleration of the expense associated with those awards. This was a onetime noncash item, and you should expect a lower corporate expense in the remaining quarters to result in our full year outlook of $110 million. If you consider the performance of our operating segments in the quarter, excluding this corporate expense anomaly, the segment margins improved from 10.3% a year ago to 10.4% this quarter. Turning to our cash performance. We had the strongest first quarter we've seen in some time. Following several years of negative free cash flow in the first quarter, this quarter was a marked improvement due in large part to the strong order activity at Gulfstream and ongoing progress payments on our large international vehicle program at Combat Systems. For the quarter, we generated operating cash flow of nearly $2 billion for a conversion rate of 270% of net income. Including capital expenditures of $141 million, our free cash flow was $1.8 billion or a conversion rate of 250%. So the quarter was well ahead of our expectations, some of which was favorable timing in our operating working capital, but the performance certainly reinforces our outlook for the year of free cash flow conversion at or above 100% of net income. Looking at capital deployment, I mentioned capital expenditures were…

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

[Operator Instructions] Our first question for today comes from Ron Epstein of Bank of America.

This is Mariana Perez Mora on for Ron today.

Before you get into your question, some of you may have noted an interesting juxtaposition of the subjects in my remarks. And I'll just note this the capacity for technology to air is endless. So nonetheless, I hope you got the message. All right, go ahead.

That's fine. We got the message, right, but we got it. So on aero, you mentioned strong volumes and margins at services, could you please give us some more color on what were the main drivers? And please help us understand how sustainable are those volumes on margins?

So we had higher R&D, but we had a very strong margin performance in services and a particularly good mix in service R&D at Gulfstream. We had also some improvement in gross margins. So that mix drove margins.

And how sustainable are the volumes of services? Did anything change in the services business?

We think that, that particular mix is going to be hard to replicate. But for the moment, we're sticking to our margin guidance that we gave you. Just to remind everybody, it is our custom to update you at the end of the second quarter with a full and detailed analysis of our prospects for the rest of the year by group and then a wrap up for the whole company. But we'll stick with what we've got now. We're off to a good start, however.

Our next question comes from Myles Walton of UBS.

Phebe, on your comment around the software validation approach and the certification, is that something that's been recently added after the original certification plan was agreed to? Or is it just that you're getting to the point where you're having to accomplish this new element of your...

No. This was an added process that we had not contemplated when we originally laid out our certification plan. And it's a result of events that are independent of us.

I see. Okay. And then on the free cash flow, Jason, is it the case it looks like unbilled was pretty favorable, and we know about the U.K. combat vehicle, but did the -- sorry, about the Canadian combat vehicle. But did the U.K. combat vehicle also start to pay out?

No. As you point out, we continue to receive steady payments on the international program that we reset a couple of years ago. So that continues apace. We're still working through issues with the customer on the U.K. side. So we hope to see that resolved later this year. .

Our next question comes from David Strauss of Barclays.

Phebe, could you touch on a little bit more on marine margins, I think at 8%, that's the lowest we've seen in a while. I think you've talked in the past about that business eventually getting 9% plus kind of margins. So can you talk about what exactly happened in the first quarter and the progression from here to get to that above 9% level?

So as we've noted before, margins will be compressed as we work down our learning curves on Colombia. And as you may recall, we are booking initial Columbia at a conservative margin. That, coupled with the well-publicized supply chain scheduling issues in Virginia, have driven some margin compression. But we expect those to stabilize over time as well.

And just to add to that, David, and put another point on what Phebe mentioned there, the Columbia program, while we saw growth, as she mentioned in all 3 of the shipyards, the Columbia program did bring more than half of the volume increase in the quarter. So just from a mix perspective, those are early margin rates on that program are impacting the aggregate margin for the group, too.

Okay. And Phebe, I mean the outlook for this business longer term, you still think it can -- as Colombia gets further into production, do you still think it can be a 9% to 10% margin business?

Yes. As we get further into production, the schedule stabilize on Virginia and both Bath and NASSCO will also contribute. So we are targeting that, and we believe that, that is fully achievable.

Our next question comes from Seth Seifman from JPMorgan.

Phebe, you mentioned the outlook for Gulfstream, both for this year and reinforced the guidance for next year. So I understand that that's where we're headed in terms of deliveries. But I guess can you walk through the mechanics a little bit more? If Gulfstream needs to see a significant step-up in deliveries at the second half at the same time that we'll be seeing incremental supply chain issues and then there might be a need to backfill some G700 deliveries in 2023 with those supply chain issues potentially still out there kind of some of the things that give you confidence in that delivery outlook given those sort of qualitative headwinds that you talked about?

So with respect to the supply chain, we are working through all of those. And we don't see those as impacting our '23 or '24 estimates that we gave you. Our estimates on Gulfstream are predicated on the current demand environment, which has been strong, as I noted, continues into this quarter along with our backlog. So we're pretty comfortable that we've got both the supply chain, the manufacturing capability to meet all of those 2 out-year requirements. And as I noted in my remarks, if -- should there be a slip, then we will increase in production aircraft this year. But look, with respect to that slip -- potential slip, we wanted to be as transparent as possible to give you some insight when we saw it and then tell you that how we were going to address that so that there's no economic impact from that in either year '23 or '24.

And then as a follow-up, Jason, I guess, maybe you mentioned you talked about addressing the debt on the next call maybe, but we could ask for a little bit of a preview. Just in terms of how you're thinking about it generally, there's probably some debt due each year for the next several years. We just saw one of your peers look to kind of term things out for a while. How do you think about where you want to take the capital structure from here and the role of debt repayment now that interest rates are going up?

Yes. I think our overarching approach to this remains unchanged. We continue to target the mid-A credit rating and want to get our metrics in line with that for the long term. In keeping with that, I think you can expect us to retire this debt that we see coming due later this year. What happens after that, I think, remains a little bit in play. We'll have to see because we talked about the elevated debt we had post CSRA acquisition and the fact that we intended to bring that down, but we never intended to get back to the level we had been with essentially 0 net debt prior to that acquisition. So now we're getting into the range looking ahead into the next couple of years where we're probably going to be evaluating, is this the place to land. We don't have an answer to that yet, but that's going to become more of the conversation. So we'll see where that plays out. I expect at this point that we'll go ahead and retire the debt that matures at the end of this year, but then we'll be more active in that conversation. But again, I think, ultimately, targeting that mid-A credit rating and everything that is attended to that.

Our next question comes from Robert Stallard of Vertical Research.

Phebe, you mentioned the very strong order performance in Aerospace this quarter. But I was wondering what sort of impact this has had on the lead time for Jet, specifically the G650 you mentioned? Whether this is starting to have any sort of impact on customer demand? Are people like saying it's going to take too long to get my jet?

No, we've managed that lead times very successfully. So present and even given the robust demand, we do not see that as an issue.

And just a follow-up, how is the pricing environment evolved over the last 3 months? .

Well, as you know, we are reticent and loathe to talk about pricing, but you can imagine that the pricing has kept pace with other economic factors.

Our next question comes from Robert Spingarn from Melius Research.

Phebe, I was hoping to dig in to Combat a little bit and just ask what types of products you expect European nations to demand most? And to what extent do you expect those to be products from Combat Systems and particularly from ELS?

So should the recent threat environment drive increased spending in rearming and recapitalizing land forces, we will see an increase in demand. And I suspect it to be aligned along our ordinance business as well as our vehicle business, both in the United States and at ELS. But I'm careful not to get ahead of our customers here.

Do you see much opportunity in technologies, perhaps for mission or even GDIT maybe on the cyber side over there?

There could be some because clearly in today's war fighting environment, interoperability on networks and communication is critical and reliable interoperability. So I suspect there could be some increased demand, but we have not seen any of that so far.

Our next question comes from Doug Harned from Bernstein.

Can you comment on inflation? When you look forward, obviously, we're in perhaps a difficult inflationary environment. In terms of how you see it affecting, both on the Gulfstream side and on the government customer side, in terms of what you can pass through? What could pressure margins?

So let me address that holistically across the company because we've dealt with inflationary pressures and increases in commodity costs in varying ways through a portfolio of actions. One is our contract architecture. A second is to the extent possible price increases. We've cut costs in other areas to offset some of the increases and then where possible we've had commodity substitutions and part substitutions. So that combination of arrows in our quiver has mitigated any impact. And at the moment, we do not project a margin compression as a result of increased prices.

So your -- so you see -- are these things that you would have not done before? Are you doing things that offset -- basically reduce your costs in other ways? Or is it more on the ability to pass through some of the price increases?

I can't give you a very -- I can't unpack that and give you a very clear distinction between which of these capabilities or which of these tools has resulted in the largest impact on our ability to offset inflationary increases, but -- because it's a combination of things. In some contracts, you've got contract architecture that protects you. In other cases, you take additional cost cuts that you had not anticipated taking before. But one of the things you expect from a company with strong operating leverage is when a cost increases somewhere else, you have to find offsetting cost reductions. And so we have historically done that, and we're continuing to do that. And then in some instances, you can have product substitutions. That's not particularly frequently, but it can happen in some critical products. So I think it's that panoply of weapons that we've used to offset these increases.

Our next question is from Sheila Kahyaoglu from Jefferies.

So I wanted to ask about R&D profile of the business for Gulfstream in 2022, '23 and '24, since you've given guidance for Gulfstream profitability. When we think about the G700, the G800 and the 400, what's the magnitude of the investment you have to put in to work with the FAA? Or is it more of a heavy time burden? Like how do we think about that, Phebe, in terms of dollar amount? Or is it just more time and a push out of notification and deliveries? .

Well, as we've noted, it's more a question of time resources, certainly on the new requirements. But you saw an increase in R&D this quarter. And it was because that we have this new set of software validation requirements that we need to walk through, and we've accommodated that in our plan. Jason, I don't know if you want to add anything to that?

Yes, just making sure we understand the nature of your question. I mean if it's about this potential risk that Phebe talked about and the additional effort we have to undertake in the certification process, it is both a time risk, but, of course, cost travels with time. And so there's the burden of the additional effort that goes on, the man hours that have to occur to accomplish those tasks. So it puts some pressure on the R&D budget. And as Phebe said, you saw some of that even in the first quarter. But I don't think any of this is enough to change the profile of what we've talked about either from an R&D spend in the aggregate in the '22, '23, '24 time frame or as we think about it in terms of the margin rate impact that it has on the business. So again, just to recap where we see this, we're in an elevated state this year. It will remain elevated in '23. And then once we get the 700 and the 800 certified, it remains somewhat elevated, but will notch down a step down in '24 as the effort shifts more towards the 400, and then we'll see it sort of return back to more of a normal run rate level beyond 2024.

And then maybe one more on technology. How are you thinking about the Technologies portfolio? I think it has a lot of good businesses in there, but organic growth hasn't been as robust as say Marine. So how do you think about the good businesses in that portfolio overall? Do you like it as a whole as a combined technology of an ammunition business? Or any thoughts to that?

Yes. We spent a fair amount of time early on after the acquisition of CSRA, trimming that portfolio both in our IT business as well as in our Mission Systems business. So we like the mix of lines of business that we have right now. We believe they're complementary, and we believe that they're good growth engines, but I don't know that we heard your questions that clearly, but if one of them was -- and correct me if I'm wrong, but if one of them was comparing this to Marine growth, very few items in the defense budget are going to grow as reliably and as robustly as the submarine and shipbuilding accounts. So I wouldn't hold that as the metric, I think continued steady growth on the top line. But more importantly, the bottom line in Technologies has really been our focus. Does that make sense?

Our next question comes from Mike Maugeri from Wolfe Research.

I think historically, sort of your commentary has been for $400 million to $500 million of annual revenue growth at Marine sort of implies some moderation from here. Growth has been strong over the last few years, maybe some risk retirements coming through on Columbia class. So with that said, I mean, is there any sort of good reason to think that growth should moderate over the next few years at Marine?

No. We continue to project $400 million to $500 million a year on average. You'll see some perturbations in quarterly growth, largely driven by material sales, but nothing that changes the trajectory.

And then sticking with Marine, can you speak to the pipeline at Bath, maybe some upside there as it might relate to hypersonic work on DDG-1000, additional work for DDG-51? Or are we sort of pretty much tapped out there from a capacity standpoint?

Well, yes, those are mixing kind of 2 different predicates. One, there's been a lot of talk about integrating various weapon systems on to shipboard platforms, but we haven't yet seen any of that materialize. And so it is not a question about capacity. We have adequate capacity that we expanded and updated and upgraded in the last few years through our capital deployment improvements at Bath and frankly, the other shipyards. So it's simply a question of the demand coming out of the U.S. Navy, and we haven't had any surprises there. They're continuing with respect to Bath and maybe have continued to support DDG-51 production. So we expect that to be a steady pace going forward.

Our next question comes from Peter Arment from Baird.

Phebe, maybe just circle back on your comment regarding the pipeline increasing potentially with Combat. I'm just curious about your overall comments on how we should expect it's eventually show up in backlog. Should we consider this more of a '23 and '24 event when we're thinking about that? And then just as a follow-up related to kind of the budget outlook, just now that we've gotten the '23 requests and we saw what was enacted for '22. Maybe you could just give some high level thoughts on GD is faring given the request?

If you're talking specifically about Combat, I think that it's hard to give projections about timing when, in fact, the budgets for the most part, have not materialized in significant increases. But were they to in the land forces and land forces modernization, we have every expectation that the vehicle -- combat vehicles demand will increase and ordinance and armaments will increase. So I think it's premature to bake in any assumptions about growth until you really see some of that. And I would say that one of the interesting things that we have not quite seen at the same level is the Abrams interest from multiple U.S. allies. So we'll have to see how that plays out over time. There are some potential out there. But as I said, I don't want to get too far ahead of our customers here, got to see how all this -- takes time to get from the threat to full funding to allocation of awards. I think you'll hear that from a lot of folks, not just us.

Our next question comes from Cai von Rumohr from Cowen.

So Phebe, at Bath you recently had a mid-contract wage hike where the lower 5 of the 10 pay grades had a pay hike of over 20%. Now I assume mix is an issue, but could you comment on what that impact is on labor availability and cost and is there any read across to electric boat that this should be a concern there, too?

So the wage increase at Bath is an attempt to help stabilize the manufacturing workforce and build ships faster. So this, in turn, will ultimately help competitiveness and margins. So we think we can fully address any cost impact. And I think the touch labor market has been less impacted by some of the well-publicized labor shortages and they tend to be more regional to the extent that they've existed. So we do -- we take each one of our lines of business on a case-by-case basis and then react accordingly. But Bath was a special set of circumstances given Maine and the realities in Maine regarding workforce.

And then switching gears a little bit, what impact do the Russian sanctions have on your business at Gulfstream? .

So to the extent that we expected an impact we anticipated it to show up at Jet Aviation in some of their European locations. But they were -- Jet was able to offset that with additional volume. With respect to Russia, as I noted, I think, before, they are less than 5% of our Gulfstream backlog and we had no deliveries this quarter, obviously. We've had no cancellations. And we have, in this demand environment, been able to manage the relatively few number of Russian airplanes in our backlog. So we do not see an impact at the moment.

Our next question comes from Matt Akers from Wells Fargo.

I wonder if you could talk on Technologies, a couple of things. I guess, one, I think you commented on some supply chain impacts on Mission Systems, just how those are trending. And then also just the timing of some of these new awards and when they get start to ramp up.

So we discussed, I think, with you, I think starting maybe in the third quarter and again in the fourth quarter, the -- some of the chip shortages that we were experiencing at Mission Systems that was constraining the ability to deliver a series of different kinds of products. So we have largely worked through those issues at Mission Systems, but we are now contending with the pent-up demand that resulted -- was generated by last year's slower deliveries as a result of chip shortages. And as we work through that, that ought to be upside for Mission Systems on the revenue side as we go forward. And then the timing of new orders typically at GDIT, they tend to be a -- tend to have a quarter lag or quarter and half lag from time of award to new starts. So we'll see some of the more recent larger awards begin to show up next quarter and then increasing over time.

And if I could on Gulfstream, I mean one of the questions I've gotten is how sort of sustainable this business could be if we do go into a recession? I guess can you just talk about if that come up at all with your customers, are people concerned about the economic outlook, and sort of how resilient do you think this business could be if we do have a downturn?

Well, we haven't heard a whole lot of that in the pipeline, but let's pass this prologue here. And I think what we have demonstrated repeatedly at Gulfstream is that Gulfstream is a very good cyclical. And in the past, what we've seen is relatively short economic perturbations and a pretty quick recovery at Gulfstream. So I think our job is to manage and play the cards that are dealt to us, and we've done so very effectively. So you can probably estimate the future of the U.S. economy better than we can. That seems to be a great support and get a Nobel prize if you get it right. But we're quite comfortable at the moment on where we stand, and I'm very comfortable with Gulfstream's ability to continue to be a good cyclical.

Our next question comes from Kristine Liwag from Morgan Stanley.

Phebe, looking at the fiscal year '23 budget request, we're seeing a generational investment in the nuclear triad benefiting the Columbia-class. And we're also seeing advanced capabilities like safety systems seeing outsized growth. So as you look at your portfolio, with the IT business stable, leverage has come significantly down, what's your appetite to add a new vertical to the business to capture more of this outsized growth in advanced capabilities that you may not have today?

No, I think we do not discuss potential acquisitions or divestitures, but we like where we are positioned to take advantage of the recapitalization of the triad. You want to ask another question?

Yes. And maybe following on capital deployment then. Understanding that you're not going to talk about large M&A, what about additional priorities for cash? How should we think about dividend payments versus share repurchases, particularly as you're in the leverage where you want to be and the business is generating significant amount of free cash flow?

I think fundamentally, there's no change to the way we've articulated our capital deployment priorities. We talked a little earlier about the dividend increase earlier this year. That was the 25th annual -- consecutive annual increase. We've made pretty clear the significant investments we've been making in the business over the past several years. And now really, if you will, if there's any pivot at all, it's shifting back the attention more toward rewarding those patient shareholders with return of capital and share repurchases. And you've seen us do that last year. We embarked on that a little bit in the first quarter, and I think you should expect to see us continue that in a tactical and opportunistic way. M&A is always opportunistic. And as Phebe said, not something that we disclose out in front of anything. So that's kind of how you should expect us to behave.

And operator, we'll take one more question, please.

Our final question for today comes from George Shapiro from Shapiro Research.

Phebe, you had $104 million cancellation in the quarter. And I guess from what you said in response to the question before, it wasn't due to Russia. So if you could tell us where that might have been?

We had one cancellation. And I have no clue where it was, but it wasn't Russia. And that...

Yes. That's fine. And then Jason, where the payments from the Canadian contract in the first quarter similar to last year's first quarter, which was around $1 billion? And also, do you expect more to occur this year as well? .

Yes. Payment levels this year are very similar to last year, both in the first quarter and for the balance of the year. So the pattern should be pretty similar. And again, that customer has been very consistent in their payments since we negotiated the recast of that program.

Thank you. That concludes the Q&A for today. I will hand back to Howard Rubel for any closing remarks.

Thank you, Alex. And thank everybody else for joining our call today. As a reminder, please refer to the General Dynamics website for our first quarter earnings release and highlights presentation. If you have any questions, I can be reached at (703) 876-3117. Thank you very much for your attention today.

Thank you for joining today's call. You may now disconnect.