GENERAL DYNAMICS CORP quarterly report, Q1 FY2016

Business context and reporting period

General Dynamics Corporation is a global aerospace and defense company operating in Aerospace, Combat Systems, Information Systems and Technology, and Marine Systems. This unaudited Form 10-Q covers the 13-week first quarter ended April 3, 2016; comparisons are with the three months ended April 5, 2015, unless otherwise noted. The company identifies the U.S. government as its primary customer.

Financial performance

Operating costs and expenses declined 1.3%, more than revenue, supporting margin expansion. General and administrative expense was $460 million, or 6.0% of revenue, versus $503 million, or 6.5%. The effective tax rate was 29.9%, compared with 29.0%.

Business groups

• Aerospace: Revenue fell 5.7% to $1.987 billion and operating earnings fell 4.6% to $411 million; margin increased to 20.7% from 20.4%. Gulfstream green deliveries were 31 versus 34; outfitted deliveries were 27 versus 32.
• Combat Systems: Revenue fell 6.6% to $1.273 billion, while operating earnings rose 6.4% to $217 million and margin expanded to 17.0% from 15.0%.
• Information Systems and Technology: Revenue declined 1.6% to $2.333 billion; operating earnings increased 14.3% to $248 million and margin rose to 10.6% from 9.2%.
• Marine Systems: Revenue increased 9.7% to $2.131 billion and operating earnings rose 2.1% to $192 million; margin declined to 9.0% from 9.7%.

Financial position and liquidity

At April 3, 2016, cash and equivalents were $1.907 billion, down from $2.785 billion at year-end. Total debt was $3.400 billion, including $501 million current debt; net debt was $1.5 billion, versus $614 million at year-end. Current assets were $14.188 billion and current liabilities $12.423 billion. The company had no commercial paper outstanding and reported $2 billion of committed bank credit facilities. A $500 million note matures in July 2016; management had not decided whether to repay it with cash or refinance. The company reported compliance with material debt covenants.

Q1 operating cash flow was $439 million and capital expenditures were $65 million. Management attributed weaker operating cash flow partly to use of customer deposits on a large Middle Eastern Combat Systems contract and increased Aerospace working capital for G500 and G600 aircraft production. Financing used $1.193 billion, including $1.026 billion of share repurchases and $215 million of dividends paid. The board authorized repurchases of an additional 10 million shares in March; 11.8 million shares remained authorized at quarter-end. The quarterly dividend declared was $0.76 per share, up from $0.69.

Total backlog was $64.7 billion, down from $66.1 billion at year-end; total estimated contract value, including potential contract value, was $89.2 billion. The company stated that it expected funds to exceed short- and long-term liquidity needs.

Changes, outlook, risks and unusual items

Management attributed the slight consolidated revenue decline mainly to lower volume in Combat Systems, Information Systems and Technology, and Aerospace, partly offset by higher Navy ship activity. It cited strong operating performance, cost-reduction efforts, and improved performance and mix in several groups as drivers of higher operating earnings and margin. Favorable revisions to contract estimates contributed $104 million, or $0.22 per diluted share, to operating earnings in Q1 2016, versus $63 million, or $0.12 per share, a year earlier; no individual revision was material.

Management’s group outlook: Aerospace revenue slightly lower and margin somewhat higher than 2015, with operating earnings expected to remain steady; Combat Systems revenue expected to increase slightly, with margin in the mid-15% range; Information Systems and Technology revenue expected to be consistent with 2015, with margin expected to approach double digits; and Marine Systems revenue expected to be consistent with 2015, with margin in the mid-9% range. Corporate costs were expected to be about $50 million. The company expected 2016 net interest expense of approximately $95 million, an effective tax rate in the mid-29% range, and capital expenditures of approximately 2% of revenue. No consolidated revenue or earnings guidance was provided in the text.

Q1 net earnings included a $13 million after-tax loss adjustment related to the 2015 sale of the axle business. The company completed two acquisitions in the quarter, in aircraft management and charter services and unmanned underwater vehicles. Risks identified include changes in government defense spending and priorities, government contract termination or restructuring, performance and cost risks on long-term fixed-price contracts, supplier issues, recovery of claims and contract adjustments, business-aircraft demand, raw-material prices, and legal or regulatory proceedings. Management did not expect litigation, environmental matters, government audits, or outstanding contract modifications and claims to have a material financial impact. Adoption of the new revenue standard was still under assessment; management expected contract-estimate changes under the required cumulative catch-up method to be potentially larger and more variable period to period.

Important facts for investors to verify

• Whether lower operating cash flow and free cash flow reflect temporary working-capital and customer-deposit timing or a more persistent trend.
• Progress on Aerospace deliveries and G500/G600 production, and the effect of aircraft mix and demand on segment margins.
• Funding, execution, and conversion to firm orders of the $24.5 billion estimated potential contract value; unfunded backlog depends on future customer funding and options.
• The outcome of the July 2016 $500 million debt maturity and the impact of continued buybacks and dividends on cash and net debt.
• How contract estimate revisions and implementation of the new revenue standard affect earnings variability and reported results.
• Any developments in government contract claims, investigations, or other contingencies that could differ from management’s stated expectations.