Good morning and welcome to the General Dynamics Third Quarter 2022 Earnings Conference Call. All participants will be in a listen-only mode. Please note, that this event is being recorded. I would now like to turn the conference call over to Howard Rubel, Vice President of Investor Relations. Howard, please go ahead.

Thank you operator and good morning everyone. Welcome to the General Dynamics third quarter 2022 conference call. Any forward-looking statements made today represent our estimates regarding the company's outlook. These estimates are subject to some risks and uncertainties. Additional information regarding these factors is contained in the company's 10-K, 10-Q, and 8-K filings. We will also refer to certain non-GAAP financial measures. For additional disclosures about these non-GAAP measures, including reconciliations to comparable GAAP measures, please see the slides that accompany this webcast which are available on the Investor Relations page of our website, investorrelations.gd.com. With that completed, I turn the call over to our Chairman and Chief Executive Officer, Phebe Novakovic.

Thank you, Howard. Good morning, everyone, and thanks for being with us. Earlier this morning, we reported earnings of $3.26 per diluted share and revenue of $10 billion. Operating earnings of $1.1 billion and net earnings of $902 million. Revenue is up, $407 million or 4.3% against the third quarter last year. Operating earnings are up $18 million or 1.7%. Net earnings are up 4.9% and earnings per share are up 6.2%. So the quarter-over-quarter results compare favorably. The sequential results are even better. Here we beat last quarter's revenue by 8.6%, operating earnings by 12.3%, net earnings by 17.8% and EPS by 18.5%. We beat consensus by $0.11 per share on somewhat higher revenue than anticipated by the sell side. Operating margin is about as anticipated. Most of the beat came from various other items including a lower tax rate than anticipated by the sell side. On a year-to-date basis, net earnings are up $93 million or 4% and earnings per share are up $0.45 a strong 5.5%. We also had another very strong quarter from a cash perspective, net cash flow provided by operating activities is $1,280 billion. Free cash flow was $1.03 billion, a 114% of net income. This follows a very strong cash performance in the first half. Order performance was good in the quarter across all segments and particularly strong at Gulfstream. You will hear more detail on cash and backlog from Jason a little later. In summary, we enjoyed a strong quarter particularly so unlighted supply chain foreign exchange and inflation headwinds. So let me move right into some color around the performance of the business segments. First Aerospace. Aerospace had revenue of $2,350 billion and operating earnings of $312 million with a 13.3% operating margin. Revenue is $281 million more than a year…

Thank you, Phebe, and good morning. Starting with our cash performance. It was another strong quarter with operating cash flow of nearly $1.3 billion. This was achieved once again on the strength of the Gulfstream orders and particularly strong cash performance from our Technology segment. This brings us to $3.9 billion of operating cash flow through the first 9 months of the year, which also includes the ongoing collections on our large international combat vehicle contract according to the contract restructure that occurred back in 2020. Including capital expenditures, our free cash flow was just over $1 billion for the quarter and $3.3 billion year-to-date, yielding a conversion rate of 137% through the first 9 months. The continued strong performance positioned us very well to achieve our target for the year of free cash flow conversion at or above 100% of net income. With respect to the status of the tax treatment of research and development expenses, I think everyone can sense that despite the broad-based bipartisan support for immediate expensing of these investments, the window of opportunity for action in 2022 is quickly closing. As we've said all throughout the year, if the Congress acts to defer or reverse the capitalization requirement, we would expect free cash flow for the year at or above 110% of net income. Looking at capital deployment. Capital expenditures were $255 million in the quarter or 2.6% of sales. That's up from last year, consistent with our expectation to be around 2.5% of sales for the year. For the first 9 months, we're at 2.2% of sales, but 2.5% remains our full year target, so obviously an implied uptick in capital investments in the fourth quarter. We also paid $345 million in dividends during the quarter, bringing the total deployed in dividends and share…

Thanks, Jason. As a reminder, we ask participants to ask one question and one follow-up, so that everyone has a chance to participate. Operator, could you please remind participants how to enter the queue?

[Operator Instructions] Our first telephone question today comes from Seth Seifman of JPMorgan. Seth, please go ahead, you may begin.

Thanks very much. Good morning. Sorry, Jason, to waste a question on pension here, but you guys are a little bit different than your peer group in terms of the way that you account for things. When we think about where interest rates and asset returns are year-to-date and we think about the income below the line next year, where that might migrate to you. And when we think about the cash impact if any, in terms of the contributions that you would expect. Can you give us an update on that?

Yes. As you said, Seth, we are somewhat different from most of the peer group in this regard. And as a result, right now, we're not expecting anything material from an income perspective on the pension front. Obviously, that's something we'll roll up as part of our full operating plan process here in the fourth quarter and give you more specific detailed guidance in January. But I think the bottom line is both from an earnings as well as from a cash perspective, we don't expect that at this point to be a material item.

Okay. Just to clarify, the $40 million or so of income below the line each quarter, that kind of continues?

Some version in that range. I don't have an exact number at this point. You can expect it to decline as you would modestly. But again, that's not 100% pension income there. It's a big piece of that is pension income on the commercial side of the business. So it should down take a little bit, but not in a material way.

Okay. Okay. And then maybe as a quick follow-up, we saw some news during the quarter about the Australian sub and the potential to do some work on that outside of Australia. And we all kind of know about the capacity constraints on sub building right now. Maybe could you talk a little bit about your thinking on that topic?

Yes. So we are driven entirely by the demand of our customer and the prioritization of our customers. So we're working with them, our U.S. Navy, to determine what the focus should be going forward. And as we work through these -- some of these capacity issues then how do we accommodate not only U.S. demand but potentially other demand.

Okay, great. Thanks very much.

Our next question today comes from David Straus of Barclays. David, go ahead.

Thanks, good morning. Phebe, were there any unusual costs at the Aerospace segment in the quarter related to the 500, 600 software fix?

Yes, David, we did have, I think you're aware, some customer accommodation related to the software issue, both in the second quarter and the third quarter wasn't material to the results, but that has been absorbed in the numbers that you see and is inherent in the improved margins that the group posted in the quarter.

Okay. And it's completely behind nothing lingering in Q4, Jason?

Right.

That's correct. It's behind us at this point.

Okay. Great. And a follow-up on free cash flow conversion. Given where you are year-to-date, I mean over 100% for the full year looks pretty conservative unless there's something unusual, I guess, from a working capital perspective that you're expecting in or baking in in Q4. Can you just elaborate on that?

Yes. As you point out, the cash flow has been particularly strong through the first 9 months. So as I said in the opening remarks, we're very comfortable with the 100-plus percent for the year. To be completely candid, there's probably some opportunity for some upside there. If I look at the things that we're monitoring, number one, to the first 9 months, we've had a significant benefit from working capital reduction. Some of that's timing. So some of that could turn in the fourth quarter. We'll watch that. The other big piece is, as I noted, we're still expecting or forecasting CapEx for the year to be in the 2.5% of sales range. So that implies a pretty meaningful uptick in CapEx in the fourth quarter. I'll acknowledge that often chased our CapEx forecast and rarely hit it. So there could be some upside opportunity there if we don't get everything in, in the year. But if we do that, that's a headwind to the fourth quarter. And frankly, the third item is something that everybody continues to monitor and that is we need to resolve our situation on the Ajax program. So those are some of the things we're monitoring for the fourth quarter. We come through all that. And certainly, to your point, we have some opportunity for some upside.

Thanks very much.

Our next question today comes from Ron Epstein of Bank of America. Ron, you may begin.

Good morning. Just maybe the supply chain question. It seems like you guys are navigating it really well. Most airplane companies today are having aren't going to deliver more than they thought they were going to deliver the opposite problem. So I guess my question for you is how is the supply chain going for Gulfstream? And then b, when you look at the defense business you have, you heard kind of across the sector, similar issues on chips and so on and so forth. How is it going there?

So we've had a fair number of supply chain challenges on the aerospace side, which we have accommodated heretofore. But supply chain remains a potential challenge going forward. And as we go through our planning process in the fourth quarter, we get a lot more clarity airplane by airplane of what the supply chain is able to do. But we have so far managed. There are, however, as you quite rightly note, a fair number of headwinds out there. On the defense side, we have accommodated most of the supply chain perturbations, except obviously in the Marine group. But most profoundly in the quarter and most impactfully is at Mission Systems. And while they had with a lot of the more pedestrian supply chain challenges, specialty chips continue to dog them and the additional delays that they experienced in the quarter were very, very hard for them, in fact, impossible for them to overcome. Mission Systems is a very high-performance organization, and they produced several high-value complex products that have experienced delays before, but again, even beyond some of the chip problems, some of the specialty products going into that production those production lines were also impacted. So the Mission System is credit. They have taken a lot of cost-cutting and restructuring initiatives to offset the margin impact and earnings impact of the revenue decline, but we're going to have to work through some of that. And so more to come as we look into the fourth quarter and then into next year.

Got it. Got it. And then maybe as a follow-on, on the labor side, what are you seeing across the businesses, right? We clearly hear from the Navy that they want to have more shipbuilders out there. But I mean what are you seeing across all the businesses you have in the portfolio in terms of skilled labor?

Yes. So there are some across the businesses, there are some specialty engineering and specialty fields that have had some headwinds on labor, but those are beginning to resolve in terms of manufacturing, we had some perturbation in -- we've had a lot of perturbation in the labor market, but felt that particularly at constant point, but that's beginning to resolve itself. When you think about shipbuilding, shipbuilding is a very complex, high touch labor business. And when you have a nationwide perturbation in the labor market is going to be impacted. I mean while we kept open, not all of the supply chain did, but we also lost a number of experienced shipbuilders as well as experienced people manufacturing folks in the supply chain. So all of that at a higher level than we normally experience. And I don't think that we are alone in that. People took the opportunity in the middle of the pandemic to retire. So we've got to work through some of that. But ultimately, we do not see and I think this is an important point here. We do not see labor as constraint for our revenue growth at the moment. Certainly not in the longer term.

Got it. Thank you.

Our next question today comes from Rod Stallard of Vertical Research. Rod, please proceed.

Good morning. Steve, your comments suggest that we're finally seeing some of this strong defense demand turning into orders. But what sort of time line are you expecting for these orders to actually convert into deliveries.

You talking about combat?

Well, across the defense divisions, but firstly, combat. Yes.

Yes. Let's talk about Combat because I think -- and then we can talk if you want a little bit about technologies. And before I get to combat, marine is pretty clear. The orders continue to be healthy. The revenue projection, while you have some quarterly lumpiness, it signifies nothing for the long-term growth. With respect to combat, we saw a number of things in the quarter, primarily Stryker and Abrams as well as MPF is beginning to ramp up as in Poland. And we saw some munitions orders also related to the Ukraine. So I suspect that -- and if we parse through, we focus in on the Ukraine, what we anticipate that our U.S. Army customers telling us they want more ammunition and munitions. So we're working with them to ramp up production. In Europe, we've seen demand for bridges because frankly, a lot of water in Europe. And we've got a very nice business in Germany to provide river crossings at various widths and weight levels. And then we’re seeing -- beginning to see increases in vehicle orders and vehicle RFPs coming out, particularly, but not exclusively in the former Eastern block. So technologies is really, I think, a tale of two cities. GDIT has had good bookings. They grew last year. We anticipate them to grow this year. This is all about Mission Systems, as I think, tried to give you a fair amount of detailed color on what's impacting them. The demand for their high-value products is out there. It's just our -- the inability to deliver because of the supply chain is constraining some of the orders, but they're there. They're just waiting to be executed once we get through all of this, and we will, we will get through it.

So just to follow up on combat, and these orders you've had from Europe, for example, is there roughly a 12-month to 2-year lead time between the contract getting signed and actually GD delivering?

Completely depends on the product. Less so on the bridge side and it depends and again, less so potentially on the vehicle side, it just depends on the vehicle, and exactly what modifications or changes folks want. We're not looking at clean sheet vehicles. We're looking at changes to existing vehicles that we have updated consistently and throughout the years. So it will depend. I suspect a year, in some cases, 18 months. Certainly, I don't expect a whole lot more than that.

Yes, it was great. Thanks so much.

Our next question comes from Myles Walton of Wolfe Research. Myles, please go ahead.

Thanks. Good morning. I know that there's the $1 billion maturity coming in November, but curious maybe, Phebe, how you're thinking about capital deployment in a broader sense, obviously, cash flow coming in ahead of expectations. I think. Go ahead.

Yes, yes. No, no, no. And that's a very good question. Our capital deployment priorities remain the same. But let me give -- ask Jason to give you a little bit more color on the details.

Yes. I think the way to think about it, Myles, we've talked about the $1 billion coming due in November. We do plan to pay that down. When you think on the debt side, we'll have additional maturities coming up in 2023, and that's where we said we'll start to look, think back to the CSRA acquisition and the additional debt we took on, we would bring it down to a point where it's some undefined point in the future, we'd start to think about whether we've hit the right level or not. And I think when we get into next year, we'll start to have that conversation in a more substantive way in terms of decision making. When you look at the other elements, share repurchase, as you know, is always tactical and opportunistic. It was a very volatile market in the third quarter. So we were a little more hands off just kind of trying to see what -- where things shake out, but that doesn't change our long-term approach to share repurchase in a tactical and opportunistic way. And I think importantly, the dividend is always going to be there. You've always heard us talk about that, and we'll continue to expect to be on that trajectory that we've been on for the past quarter century, frankly. So as Phebe said, no changes in the deployment strategy. It will just be a matter of what's in the moment in a given quarter. And I think importantly, our cash flow performance and our liquidity resources afford to see optionality to address all of those priorities without having to forgo one for the sake of the other.

And just a quick follow up, Phebe said, it’s the M&A market attractiveness. Is that improved become worse the same?

We're just not going to comment on M&A. So I think we can leave it at that. You want one more shot, one more question?

No. I'll stay through. I don't want to get Howard Angry.

Yes, that's a scary thing, Isn't it?

Our next question comes from George Shapiro of Shapiro Research. George, go ahead.

Yes. Jason, I wonder if I could pin you down a little bit as to how big a number of the software fixes were in the margin for Gulfstream in the quarter. Are we talking a few million dollars or something more?

George, I don't actually have a discrete number on the software fix. I mean, I have a sense of the overall R&D budget and that sort of fits into that context. So I think as David asked earlier in terms of impacts to aerospace in the quarter, you saw the nice margin improvement, frankly, even a little bit ahead of where we were expecting, which is why as Phebe alluded, we think we'll -- the group perform better for the full year. But even within those strong results in the quarter, we did have an impact, an adverse impact in terms of the accommodations we made with customers on the 500, 600 airworthiness directive. Again, that's fully behind us. And we are in a, at this point, sustained elevated R&D mode. Part of that was the resources that were diverted from the 700 over to the 500, 600 AD fix, and that will sustain through next year, as we've talked about as we continue towards certification of the 700 and then ultimately the 800. So I'll give you a little more color around that, but I apologize, I don't have a discrete number around the airworthiness directed fix.

Okay. And then a quick one, Phebe, a usual question. There's a $59 million difference between the gross and the net bookings in Aerospace. Was that a cancellation? Was it FX related? Or if you can quantify that?

All of the above. I mean really absolutely immaterial.

Okay. And let me sneak in one last one.

You're risking Howard's ire. Go, George.

I always got Howard's ire. That's okay. when you commented about your deliveries in '23 and '24, it presupposed the book-to-bill of 1. Obviously, we've run a lot better than that. So are you thinking of changing those delivery forecasts or just stay conservative with the delivery forecast that you have out there?

Not at the moment. We assumed 1:1, and at the moment, I don't see any reason to change that. But as we go through our planning process, to the extent that we need to modify it, we certainly will and we'll be very explicit about that in the fourth quarter.

Okay. Thanks very much.

Our next question comes from Kristine Liwag of Morgan Stanley. Please go ahead.

Kristine. Hello?

Sorry about that. You guys hear me.

Yes.

Okay. Great. Thanks. Good morning, everyone. And Phebe, on international defense sales, we're seeing changes in relationship between the U.S. and Saudi Arabia. With your foreign military sales to Saudi Arabia through Canada, how do we think about this evolving relationship potentially affecting your business?

We see no indication of that in a moment. You want to ask one more.

Yes, following up on what George was asking about on aerospace. I mean book-to-bill was at 1times at aerospace. We've seen this above 2 times in the past few quarters. But at the same time, the backlog is at record levels. Can you provide some color on the demand resilience you're seeing? Is this a demand from corporate customers, individuals? And then also, is there some sort of level of backlog where you're comfortable at so not to extend the duration of when people have to wait for their aircraft. Any color you could provide there would be really helpful.

Sure. So we -- let's take your question in the inverter. We always watch the delivery times for our aircraft to our customers. And so far, that's all been manageable. Well, just to remind you, starting in mid-February of last year, we frankly entered the hottest in notranic demand market that I've ever seen. And the order level in the quarter was by any measure, spectacular. So we've seen strong U.S. demand, Fortune 500 Mideast, Southeast Asia. And our demand interestingly, and I think not surprisingly, our pipeline going into the fourth quarter looks very much like the pipeline going into the third quarter. So at the moment, we've got some pretty good visibility of what orders look like.

Our next question comes from Cai Von Rumohr of Cowen. Cai, please go ahead.

Yes. Thanks so much, and good results, Phebe. So how is the software accommodation split between the second and third quarter. And as we look going forward, with that out of the way, and presumably R&D flat to down and volume up, what should we look for about the margins in the fourth quarter and going forward?

So we'll see some margin upside, which we alluded to or about stated rather, in our guidance for the year. But the software fixes work almost entirely done by the end of the second quarter and the financial issue, it's about 50-50. So we're -- we like where we are. And frankly, you haven't asked this, but let me just give you a little bit of transparency around that. The transparency of the engineering resources that -- and the cooperation between the FAA and the Gulfstream was very strong and very apparent throughout that process. So we expect that kind of relationship to continue.

If I could add just 1 thing. Cai, there was a predicate in your question that R&D would be coming down, we don't yet expect R&D to be coming down. If you look through next year with the 700 and the 800 will remain at a sustained and potentially even elevated level next year. So I just want to make sure that point is also clear.

Yes. Good point.

Excellent. And as a follow-up, if we turn to GDIT, you mentioned $3.5 billion in protest, $17 billion in bids awaiting. How does that compare with the second quarter? And given that they lifted the occupancy restrictions at DoD in the middle of September, have we seen a pickup in any of that flowing through to bookings?

Yes, we have. But tell me again what the first part of your question was?

Well, you had $17 billion in business awaiting at $3.5 billion in progress.

Some of the protests have resolved to our favor. And these are -- when we say protest, these are items that we've won that have been protested. And we've got one in there that's got to be approaching the federal level of number of protests. So hopefully, we'll get through that in the fourth quarter. And I think there's -- it's down somewhat, as I said, because they've resolved. But we still see a fair amount of proposals in the decision-making cycle, which has, as we've said elongated. But even given that, GDIT continues to grow.

Thank you, very much.

Our next question comes from Ken Herbert of RBC. Ken, proceed.

Yes, good morning. Thank you. I wanted to first ask on the schedule for the 7 and the 800. Is it fair to assume that resources that were diverted from the 700 are now 100% back on that program? And in the last few months, considering issues, okay, great, considering issues on the 5 and 6 have been resolved. Are you seeing anything else from the FAA that could potentially put entry to service schedules at risk?

So as I said, we've cooperated very well with the FAA. We expect that to continue. I would note that we learned a lot in that process of how to work through the new software requirements from the FAA. I think that, coupled with the fact that the G700 is the most mature aircraft to enter the FAA certification process as a result of its software system and considerable and successful testing that preceded FAA review. We see -- we're sticking with our at the moment with our summer 2023 estimate. But look, when we give you sort of our best guess on when the certification is. That's a result of a lot of things that we control and that we can talk about with certainty. But ultimately, this is an FAA issue, and it's the availability of their resources, and they are the regulator and they're going to control it. So we've always tried to be transparent about that, but recognize that the U.S. government controls ultimately the pace.

Okay. Very helpful. And if I could, just 1 quick follow-up. On the defense side, how would you look at the risk of your business if for whatever reason, we have a continuing resolution that extends into calendar '23?

At the moment, we don't see a particular risk. And if we get 3 to 4 quarters in the entire year of a CR, which I find in this threat environment, very difficult to imagine. And we'd have to come back at you. But nothing we hear would suggest that it's the desire of Congress to do that.

Great. Thank you.

Our next question comes from Doug Harned of Bernstein. Doug, please go ahead.

Good morning. Thank you. When you look at the demand you're seeing at Gulfstream right now, can you give us kind of a picture of how this looks? And what I mean is we're seeing a lot of things such as first-time customers going straight to large cabin jets, perhaps shifts in international versus U.S. Can you give us a picture of what that outlook is today for you? And has that changed some over the past couple of years?

So I think you and I, a couple of years ago, had a discussion about structural versus cyclical change. And I still think it's premature to see any to declare that there's been a structural change. We've certainly seen some increase in first-time buyers, but that was in part because a lot of wealth was created during the pandemic. The higher the pandemic. So I don't have exact data about what's in the pipeline, but I can imagine that it will be much different than this quarter, which is heavy U.S. Fortune 500, again, Southeast Asia and the Middle East.

And then just switching over, earlier when you talked about munitions, this is something that also looks like -- it looks like there's a lot of potential growth here. How do you think about this? I mean, I think of it as a high-margin business for you within Combat and potential to have orders well beyond that 3.70 that you got this quarter?

So -- and I think I may have alluded to this in my remarks that, our customer has expressed an interest in increasing that demand. So we're working with them on increasing production. But I think your predicated about a high-margin business is not quite based. In fact, we are -- OTS where we do all of this work is a high-performance organization with respect to operating leverage. But that comes from a very wide and vast portfolio. So we do okay, but I wouldn't say that they were additive.

So you don't think of it as a higher-margin business. I just thought traditionally, it was a higher-margin business than perhaps some of the other parts of combat vehicles, and that's not the case?

OTS, on occasion, will be a higher-margin business, but that's largely about mix, and it's not driven by 1 particular line of business. They've got an awful lot of contracts and the high-velocity contract turnover. So I think that's how you should think about them.

Thanks, Doug. Lisa, we'll take one more question, please. This will be our final.

Our final question today comes from Scott Deuschle of Credit Suisse. Go ahead.

Good morning. Thanks for taking my question. Jason, I think ROIC is something that you've historically been very focused on. And honestly, it's held up really well here despite the capital that you put in the business. So just curious, as you get past the bulk of the CapEx phase of marine working capital comes out of the business and you have margins reflected aerospace? Where do you think ROIC can go over the next few years?

It's a great question. Obviously, as we've been in this period of extended investment, you'd expect to see ROIC become a little bit muted as a result. And we saw a little bit of a downtick in that during that investment period. But as we emerge having had essentially the investment period behind us. To your point, we absolutely expect to see ROIC back on decline. We'll see that this year, and we expect to see it next year and beyond. So our targets over the long term ought to be back in the range as we were in prior to the investment period we entered into a few years ago, and that's what you should expect as well.

Okay. Great. And then Jason, does the recently announced facility expansion of Savannah, does that have any impact to the prior guidance you gave on '23 CapEx? Or was that embedded in the 2% figure you previously talked about? Thank you.

Yes, that's all embedded and now look we've given previously. So no change to those projections.

Great. Thank you so much.

Thank you. That concludes the Q&A session. I'll hand back to the management team for any closing remarks.

Thank you all for joining us today. As a reminder, please refer to the General Dynamics website for both our earnings release and, of course, our highlights presentation. If you have any other questions, I can be reached at 703-876-3117. Thank you.

Thank you all for joining today's call. You may now disconnect your lines.