General Dynamics Corporation — Q2 2016 Form 10-Q
Reporting period: Three and six months ended July 3, 2016; comparative periods ended July 5, 2015. The filing is unaudited. General Dynamics operates in Aerospace, Combat Systems, Information Systems and Technology, and Marine Systems, serving U.S. and international government customers and business-jet customers.
Financial results and condition
Dollars in millions, except per-share amounts and margins.
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Revenue | $7,665 | $7,882 | $15,389 | $15,666 |
| Operating earnings | $1,070 | $1,081 | $2,123 | $2,108 |
| Operating margin | 14.0% | 13.7% | 13.8% | 13.5% |
| Net earnings | $758 | $752 | $1,475 | $1,468 |
| Diluted EPS | $2.44 | $2.27 | $4.73 | $4.41 |
- For the six months, continuing-operations earnings were $1,488 million, or $4.77 diluted EPS; discontinued operations recorded a $13 million loss related to the 2015 axle-business sale.
- Six-month net cash from continuing operating activities was $873 million, down from $1,433 million. Capital expenditures were $134 million, yielding free cash flow from operations of $739 million, versus $1,243 million.
- At July 3, cash and equivalents were $1.899 billion, down $886 million from year-end. Debt was $3.436 billion; management reported net debt of $1.5 billion, versus $614 million at year-end. A $500 million note was repaid at maturity after quarter-end.
- Current assets were $14.386 billion and current liabilities $12.135 billion. The company had no commercial paper outstanding and had $2 billion of committed credit facilities available; it reported compliance with debt covenants.
- Six-month revenue fell 1.8%, while operating earnings rose 0.7% and operating margin expanded 30 basis points. Excluding a $23 million prior-year business-sale gain, management said margin increased 50 basis points.
Material changes and business-group performance
- Aerospace: Six-month revenue fell 5.6% to $4.121 billion and operating earnings fell 2.9% to $845 million. Gulfstream green deliveries declined to 62 from 70 and outfitted deliveries to 61 from 73. Margin improved to 20.5%, supported by cost savings and stronger services performance.
- Combat Systems: Six-month revenue declined 6.6% to $2.588 billion, while operating earnings increased 1.4% to $436 million and margin rose to 16.8%. Lower international vehicle activity, program transitions, product delays, and currency translation weighed on revenue.
- Information Systems and Technology: Six-month revenue decreased 0.5% to $4.562 billion; operating earnings increased 8.4% to $492 million. Excluding the prior-year $23 million sale gain, margin improved 140 basis points, reflecting performance and program mix.
- Marine Systems: Six-month revenue grew 4.4% to $4.118 billion, mainly from Virginia-class submarine construction and Ohio-class replacement development work. Operating earnings were nearly flat at $373 million; margin declined to 9.1% on contract mix.
- Customer advances and deposits fell to $5.365 billion from $5.674 billion at year-end. Management attributed weaker operating cash generation partly to using customer deposits on a large Middle Eastern Combat Systems contract and to Aerospace inventory buildup for the G500 and G600 programs.
- Backlog was $63.2 billion, down 2.3% from the prior quarter; total estimated contract value, including potential awards and options, was $89.1 billion. Defense backlog was $51.5 billion. These figures include unfunded work and options and are not equivalent to firm funded orders.
Outlook, commentary, risks, and unusual items
- Management described Q2 operating performance as strong, with a 14.0% operating margin and operating earnings above $1 billion for the seventh consecutive quarter.
- 2016 group outlook: Aerospace revenue of $8.5–$8.6 billion and margin slightly above 20%; Combat Systems revenue expected to increase slightly and margin approximately 16%; Information Systems and Technology revenue expected up slightly with margin in the mid-to-high 10% range; Marine Systems revenue somewhat higher with margin in the low 9% range. Corporate costs were expected to be about $40 million.
- Other full-year expectations included capital expenditures of about 2% of revenue, net interest expense of approximately $95 million, and an effective tax rate of approximately 29%. Management said it expected funds to exceed liquidity needs.
- Contract estimate changes increased operating earnings by $83 million in Q2 and $187 million in the first half of 2016; no individual contract adjustment was material. The company recognizes such estimate changes prospectively under its current method.
- The adoption of share-based compensation guidance produced an approximately $30 million tax benefit in the first half. Management expected the second-half benefit to be lower. Adoption also shifted $60 million of cash-flow classification from financing to operating activities in the first half.
- Electric Boat faces a U.S. Department of Justice investigation, a related sealed lawsuit, and a Navy Show Cause Letter concerning oversight of supplier quality systems and alleged non-conforming parts. The company could not estimate a reasonably possible loss; an adverse outcome could materially affect results, financial condition, or cash flows.
- The company cited risks including government budget and contract changes, fixed-price contract performance, supplier issues, contract claims, business-aircraft demand, input costs, and legal or regulatory outcomes. Revenue-standard adoption was expected in 2018; the company had not completed its impact assessment or selected a transition method and expected potentially larger, more variable contract-estimate adjustments under the new method.
Important facts for investors to verify
- Whether management’s 2016 segment revenue and margin outlooks were achieved, particularly Gulfstream delivery assumptions and Combat Systems’ expected revenue recovery.
- Whether operating cash flow and free cash flow recover as customer deposits are used and G500/G600 inventory builds; assess cash conversion alongside earnings.
- The status and potential financial consequences of the Electric Boat supplier-quality investigation, lawsuit, and Navy Show Cause process.
- How much reported backlog is funded, and whether potential contract value and options convert into funded orders and revenue.
- The eventual effects and transition method for the new revenue-recognition standard, including impacts on contract-estimate volatility.