General Dynamics Corporation — Q2 2017 Form 10-Q
Reporting period: Quarter and six months ended July 2, 2017; comparisons are to the periods ended July 3, 2016. Amounts are in millions of dollars except per-share data, percentages, and aircraft deliveries. The 2016 comparisons reflect retrospective adoption of ASC 606.
Business context and results
General Dynamics operates in Aerospace, Combat Systems, Information Systems and Technology, and Marine Systems. Its customers include the U.S. government, foreign governments, and business-jet buyers. Most defense revenue comes from long-term contracts; new business-aircraft revenue is generally recognized upon customer acceptance.
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Revenue | $7,675 | $7,774 | $15,116 | $15,250 |
| Operating earnings | $1,056 | $1,027 | $2,091 | $1,951 |
| Operating margin | 13.8% | 13.2% | 13.8% | 12.8% |
| Net earnings | $749 | $714 | $1,512 | $1,355 |
| Diluted EPS | $2.45 | $2.30 | $4.94 | $4.35 |
Cash flow, balance sheet, and capital allocation
- First-half operating cash flow was $1,010, versus $873 a year earlier. Capital expenditures were $153; free cash flow, as defined by the company, was $857 versus $739.
- Cash and equivalents were $1,856 at July 2, down $478 from year-end 2016. Current assets were $17,126 and current liabilities were $13,503.
- Total debt was $3,978 carrying value ($4,011 principal); reported net debt was $2.1 billion, compared with $1.6 billion at year-end 2016. The $900 principal notes mature in November 2017. The company had no commercial paper outstanding, $2 billion of committed credit facilities, and was in covenant compliance.
- First-half share repurchases were $901 cash-flow-statement value ($893 in the equity rollforward), covering 4.6 million shares; dividends paid were $483. The quarterly dividend was raised to $0.84 per share.
- Operating cash flow was affected by working-capital growth, including higher unbilled receivables. Unbilled receivables rose to $5,045 from $4,212, partly because of billing timing on a large Middle Eastern customer contract.
Material changes and segment performance
Revenue declined 1.3% in Q2 and 0.9% for the first half, while operating earnings and margins improved. Management attributed the margin expansion mainly to better performance in Aerospace and Information Systems and Technology, and to a lesser extent Combat Systems. Revenue weakness reflected fewer aircraft deliveries and lower Information Systems and Technology volume; ship services and Combat Systems programs partly offset the declines.
- Aerospace: Q2 revenue fell 9.0% to $2,078; operating earnings were essentially flat at $425, with margin rising to 20.5%. Gulfstream deliveries were 30 versus 36. First-half revenue rose 2.1% and operating earnings rose 14.8%.
- Combat Systems: Q2 revenue increased 9.0% to $1,414 and operating earnings increased 9.8% to $225. Growth included Stryker vehicles and weapons and munitions.
- Information Systems and Technology: Q2 revenue decreased 5.0% to $2,104, but operating earnings rose 2.6% to $240 and margin improved to 11.4%. Lower CHS-4, WIN-T, and Department of State program volume was offset in profitability by performance and mix.
- Marine Systems: Q2 revenue increased 5.1% to $2,079 and operating earnings rose 3.5% to $178. First-half revenue and earnings declined 2.1% and 4.8%, respectively; results included a scheduled delivery delay on a Virginia-class submarine, delivered in Q2.
Total backlog was $58.6 billion, down from $60.4 billion at April 2, 2017; estimated total contract value including potential awards and options was $83.0 billion. The company expected to recognize approximately 55% of remaining performance obligations as revenue by 2018 and a further 30% by 2020.
Outlook, risks, and unusual items
- Segment 2017 outlook: Aerospace revenue approximately $8.1 billion and margin 19.5%–19.6%; Combat Systems revenue growth approximately 7% and margin 15.6%–15.7%; Information Systems and Technology revenue essentially flat from 2016 and margin 11.2%–11.4%; Marine Systems revenue approximately $8.1 billion and margin around 8.6%.
- Other company estimates: full-year net interest expense approximately $105; effective tax rate approximately 27.5%; capital expenditures approximately 2% of revenue; corporate operating costs approximately $50. The filing does not provide consolidated revenue or EPS guidance.
- Contract-estimate adjustments increased operating earnings by $121 in Q2 and $171 in the first half, adding $0.26 and $0.36 to diluted EPS, respectively. No single contract adjustment was material; such estimates may change and are recognized using cumulative catch-up accounting.
- A Department of Justice investigation, related sealed lawsuit, and Navy show-cause matter concerning Electric Boat’s supplier quality oversight remain unresolved. The company could not estimate a reasonably possible loss; an adverse outcome could materially affect results, financial condition, or cash flows.
- Other disclosed risks include government budget and contract changes, fixed-price contract cost overruns, supplier performance, aircraft demand, claims recoveries, commodity costs, and litigation. Management said other routine legal and environmental matters were not expected to be material.
- ASC 606 adoption changed revenue timing and presentation; it reduced retained earnings by $372 million on January 1, 2015. Business-jet revenue is now generally recognized at final customer acceptance. First-half 2016 results are restated for comparability.
Investor verification priorities
- Track backlog conversion, funding and option exercise, particularly the decline in total backlog and the distinction between firm backlog and estimated potential contract value.
- Monitor Aerospace delivery mix and demand, especially Gulfstream production and the G500/G600 entry-into-service schedule.
- Assess unbilled receivables, working-capital recovery, and billing and collection timing on the Middle Eastern contract and new aircraft programs.
- Review whether contract-estimate gains recur and how fixed-price program performance affects margins.
- Follow the November 2017 debt maturity and management’s repayment or refinancing decision.
- Monitor developments in the Electric Boat investigation and related proceedings, for which potential loss is not estimable.