General Dynamics Corporation — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018. Financial statements are unaudited. General Dynamics is a global aerospace and defense company with five operating segments: Aerospace, Combat Systems, Information Technology, Mission Systems and Marine Systems.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $9.094B | $7.580B | $25.815B | $22.696B |
| Operating earnings | $1.135B | $1.063B | $3.231B | $3.176B |
| Operating margin | 12.5% | 14.0% | 12.5% | 14.0% |
| Continuing-operations earnings | $864M | $764M | $2.449B | $2.276B |
| Net earnings | $851M | $764M | $2.436B | $2.276B |
| Diluted EPS | $2.85 | $2.52 | $8.12 | $7.45 |
Revenue rose 20.0% in Q3 and 13.7% year to date, mainly reflecting CSRA, acquired April 3, 2018. Operating earnings grew more slowly, and operating margin fell 150 basis points in both comparisons. The company attributed margin pressure to CSRA intangible-asset amortization and acquisition-related charges, as well as a less favorable Gulfstream aircraft delivery mix. Q3 net earnings include a $13M after-tax discontinued-operations loss; the related sale generated taxable gain but no GAAP accounting gain.
Cash flow and liquidity: Nine-month operating cash flow was $1.081B, down from $1.882B; capital expenditures were $447M, producing company-defined free cash flow of $634M versus $1.609B. Management cited working-capital growth, particularly on international vehicle contracts and the G500/G600 programs, and a $255M discretionary pension contribution as cash-flow pressures. Cash was $1.010B at quarter-end versus $2.983B at year-end 2017. Current assets were $19.958B and current liabilities $15.689B.
Debt: Debt principal was $13.191B, compared with $4.032B at December 31, 2017; reported debt was $13.081B after issuance costs and discounts. Management reported net debt of $12.1B versus $1.0B at year-end, primarily due to financing CSRA. The company had $1.7B of commercial paper outstanding and $5B in committed credit facilities, and reported compliance with debt covenants.
Material changes and business developments
- CSRA was acquired for a total purchase price of $9.749B. The preliminary allocation included $7.792B of goodwill and $2.069B of intangible assets; valuations remained subject to completion. CSRA contributed approximately $1.2B of Q3 revenue and $2.5B of nine-month revenue, before specified amortization and financing effects.
- Information Technology revenue increased 116% in Q3 and 85.2% year to date, largely from CSRA. Reported segment margins declined, chiefly because of acquired-intangible amortization; excluding that amortization, management said margins improved.
- Aerospace nine-month revenue declined 6.4%, with Gulfstream deliveries down to 79 from 90. The first G500 was delivered in Q3 after FAA certification; G600 certification and 2019 entry into service remained anticipated.
- Defense-segment backlog was $57.7B. Total backlog was $69.5B, up from $66.3B at the prior-quarter end; total estimated potential contract value reached $104.2B. A $3.9B Navy award for four Arleigh Burke-class destroyers was a major backlog driver.
- Unbilled receivables increased to $7.564B from $5.240B at year-end; the company attributed the increase, excluding CSRA, primarily to large international vehicle contracts. Inventories rose to $6.247B from $5.303B, primarily reflecting G500/G600 production ramp-up.
Outlook, risks and contingencies
Management’s 2018 segment outlook: Aerospace revenue around $8.5B, operating earnings approximately $1.5B and margin in the high-17% range; Combat Systems revenue approximately $6.2B and margin in the mid-15% range; Information Technology revenue approximately $8.2B and margin in the low-7% range; Mission Systems revenue of $4.8B–$4.9B and margin around 14%; Marine Systems revenue slightly above $8.5B and margin in the mid- to high-8% range. Other expectations included net interest expense of approximately $355M, net other expense of approximately $25M, a full-year effective tax rate in the low-18% range, and capital expenditures slightly above 2% of revenue. These are forward-looking estimates, not guarantees.
Key risks include government budget and contract changes, execution and cost estimates on long-term fixed-price contracts, supplier and subcontractor performance, aircraft demand and program transitions, and outcomes of legal or regulatory matters. General Dynamics said it could not estimate a reasonably possible loss for the Electric Boat investigation and related False Claims Act and Navy proceedings concerning supplier quality oversight; an adverse outcome could materially affect results, financial condition or cash flows. The company reported other litigation, environmental matters, government audits, contract claims and approximately $1.4B of letters of credit, guarantees and similar arrangements; it did not expect these other matters to be material based on information then available.
Management stated disclosure controls were effective, but the assessment did not include CSRA’s internal controls over financial reporting. The filing also notes that long-term contract estimates and the preliminary CSRA purchase-price allocation involve significant judgments and may change.
Important facts for investors to verify
- Whether CSRA integration, cost synergies and acquired-contract margins develop as expected, and how final purchase accounting affects amortization and goodwill.
- Whether working-capital investment and unbilled receivables convert into billings and cash, and whether operating cash flow recovers from the year-to-date decline.
- Progress on G500/G600 deliveries, certification, costs and margins, alongside Gulfstream demand and aircraft mix.
- Execution, funding and profitability of major defense programs and the conversion of funded and unfunded backlog into revenue and cash.
- Developments in the Electric Boat matter, including any government action, potential loss exposure or effect on contract eligibility.
- Debt repayment, interest costs and liquidity following the CSRA-financed increase in leverage.