Business context and reporting period
General Dynamics Corporation is a global aerospace and defense contractor operating through Aerospace, Combat Systems, Information Systems and Technology, and Marine Systems. Its primary customer is the U.S. government; approximately 60% of revenue is government-funded. This unaudited Form 10-Q covers the three months ended April 2, 2017, compared with the three months ended April 3, 2016.
Key financial results
| Metric | Q1 2017 | Q1 2016 | Change |
|---|---|---|---|
| Revenue | $7.441 billion | $7.476 billion | Down 0.5% |
| Operating earnings | $1.035 billion | $924 million | Up 12.0% |
| Operating margin | 13.9% | 12.4% | Up 150 basis points |
| Net earnings | $763 million | $641 million | Up 19.0% |
| Diluted EPS | $2.48 | $2.04 | Up 21.6% |
| Operating cash flow | $533 million | $480 million | Up $53 million |
| Free cash flow from operations | $471 million | $415 million | Up $56 million |
Cash from operations was 70% of earnings from continuing operations, versus 73% in the prior-year quarter; free cash flow was 62%, versus 63%. Capital expenditures were $62 million. The effective tax rate was 24.5%, compared with 28.3%.
At April 2, cash and equivalents were $2.168 billion; total debt on the balance sheet was $3.889 billion, including $901 million current debt. Management reported net debt of $1.7 billion, versus $1.6 billion at year-end 2016. The company had no commercial paper outstanding and had $2 billion in committed credit facilities available. A $900 million note matures in November 2017; management had not decided whether to repay or refinance it. The company reported compliance with its debt covenants.
Material changes and operating performance
- Revenue was nearly flat overall, but lower costs and stronger execution lifted operating earnings and margin. Management characterized the quarter’s performance as strong and the 13.9% margin as a record.
- Aerospace revenue rose 16.5% to $2.074 billion and operating earnings rose 33.4% to $443 million, helped by additional Gulfstream deliveries, favorable delivery mix and cost containment. Gulfstream deliveries were 30 versus 28.
- Combat Systems revenue increased 3.4% to $1.287 billion and operating earnings increased 9.6% to $205 million, with higher U.S. military vehicle volume and improved performance.
- Information Systems and Technology revenue declined 7.8% to $2.146 billion, while operating earnings were nearly unchanged at $236 million. Lower C4ISR and IT-services activity was partly offset by improved margins on mature programs.
- Marine Systems revenue fell 8.9% to $1.934 billion and operating earnings fell 12.5% to $161 million, mainly due to lower ship-construction volume and a delayed Virginia-class submarine delivery.
- Backlog was $60.4 billion, down from $62.2 billion at December 31, 2016; funded backlog rose to $53.3 billion. Management estimated total contract value, including potential contract value, at $85.0 billion.
Operating cash flow improved year over year, although working-capital growth in Aerospace, including inventory buildup for the G500 and G600 programs, was a cash use. Financing cash outflow was $606 million, including $354 million of share repurchases and $230 million of dividends paid. The quarterly dividend declared increased to $0.84 per share from $0.76.
Outlook, risks and unusual items
- 2017 group outlook: Aerospace revenue growth of about 6%, with operating margin in the low-19% range; Combat Systems revenue growth of 6%–7%, with margin in the mid-15% range; Information Systems and Technology revenue up slightly, with margin around 11%; Marine Systems revenue down slightly, with margin expected in the mid-8% range.
- Other 2017 expectations include corporate operating costs of about $55 million, net interest expense of about $110 million, an effective tax rate of about 28%, and capital expenditures of approximately 2% of revenue. Management expects funds to exceed short- and long-term liquidity needs.
- The continuing resolution funding the U.S. government at prior-year levels was in effect through April 28, 2017. Management said it had not materially affected results and did not expect a full-year extension to have a material effect, while noting the timing of appropriations remained uncertain.
- Remaining performance obligations were $60.4 billion. The company expects to recognize about 30% as revenue in 2017, another 45% by 2019, and the balance thereafter. Funding and timing are not assured for all defense backlog and potential contract value.
- Long-term contract estimates require judgments about costs, productivity, suppliers, funding and contract claims. Estimate changes increased Q1 2017 revenue by $72 million and operating earnings by $50 million, or diluted EPS by $0.11; the comparable 2016 earnings benefit was $58 million, or $0.12 per diluted share. No single adjustment was material.
- Electric Boat faces a U.S. government investigation, related lawsuit and Navy show-cause process concerning quality-system oversight of supplier parts. The company could not assess the outcome or estimate a possible loss; an adverse outcome could materially affect results, financial condition or cash flows. Other disclosed litigation and environmental exposures were not expected to be material.
- ASC Topic 606 was adopted retrospectively from January 1, 2017, changing, among other things, business-jet revenue recognition to generally occur upon customer acceptance of the completed aircraft. Prior-period results were restated; reported comparisons reflect the revised accounting. Management cautions that contract estimates and forward-looking expectations may differ from actual outcomes.
Important facts for investors to verify
- Whether the 2017 segment revenue and margin outlook is supported by aircraft deliveries, program execution and customer demand.
- How the U.S. budget and appropriations process affects defense funding, contract awards and the funded portion of backlog.
- Progress on G500/G600 production and related working-capital needs, and conversion of backlog into revenue and cash.
- The resolution and potential financial exposure of the Electric Boat quality-system investigation and related proceedings.
- The November 2017 $900 million debt maturity and the company’s eventual repayment or refinancing plan.
- The impact of ASC 606 and cumulative contract-estimate adjustments when comparing reported results across periods.