Good morning and welcome to the General Dynamics First Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I'd now like to turn the conference over to Howard Rubel, Vice President of Investor Relations. Please go ahead.

Thank you, Chad and good morning, everyone. Welcome to the General Dynamics' first quarter 2020 conference call. Any forward-looking statements made today represent our estimates regarding the company's outlook. These estimates are subject to some risks and uncertainty. Additional information regarding these factors is contained in the company's 10-K, 10-Q and 8-K filings.

Thank you, Howard. Before I address the company's performance in the quarter, let me take a moment to discuss General Dynamics' response to COVID-19 and its impact on us. We've been designated a national critical infrastructure company and as such are required to continue full operations, which we have done. I am proud of our patriotic employees who have continued to work hard to fulfill their mission in support of our armed forces as we face this crisis together. Our men and women in uniform continue to serve and we must as well. Ensuring a safe work environment for our workforce has been and remains our top priority. We have 39,000 employees tele-working from home; unfortunately, our large manufacturing sites cannot do that. At these sites, we follow CDC recommended guidelines and practice social distancing where possible. We have increased shift work and the use of PPE. We are conducting temperature screening where feasible. As additional screening and ultimately testing become available, we will aggressively implement those as well. Our leadership teams have been and will continue to be in the workplace leading our people. This is early in the COVID-19 crisis and its impact on our business. So far we've experienced some deterioration in efficiency driven by absenteeism at a couple of our facilities. We expect absenteeism to decline as we see the rate of infection slow. We're also incurring rather significant costs to sanitize the work environment in our facilities and to provide additional PPE. We've also seen definite weaknesses in the supply chain, particularly with respect to some of Gulfstream's suppliers. Gulfstream is working closely with the suppliers who have also been hurt by the disruptions of the commercial airplane OEMs. Hopefully, we can sort our way through these issues, but some of them are difficult. The Department of Defense is accelerating payment to us to support the defense industrial base. We believe that this will prove to be very helpful. Regarding the company's first quarter performance, as you can discern from our press release, we reported earnings of $2.43 per diluted share on revenue of $8.75 billion, operating earnings of $941 million, and net income of $706 million. Revenue was down $512 million or 5.5% against the first quarter last year. Operating earnings were down $73 million or 7.2%, and net earnings were down only $39 million or 5.2%.

Thank you, Phebe and good morning. The first thing I would like to note is a key accomplishment on the financing front in the quarter. In anticipation of the pending maturity of $2.5 billion of notes in May of this year and given the extreme volatility we've seen in the markets since the outbreak of the pandemic, we issued $4 billion of fixed-rate notes in late March at very attractive rates. While this financing was part of our planning pre-COVID-19, the additional liquidity enhances our financial flexibility during the pandemic, particularly in light of the fact that our free cash flow is weighted toward the second half of the year. To that point, our free cash flow in the quarter was negative $851 million. The cash performance in the quarter was impacted by the COVID-19 outbreak most notably at Gulfstream due to delayed customer payments associated with the net 11 airplanes we weren’t able to deliver. As Phebe noted, customer orders were also postponed in the last two weeks of the quarter. On the defense side, we've seen accelerated payments coming from some of our customers starting in the month of April in the form of increased progress payment rates and other contract mechanisms, but we've passed those monies on to our suppliers to help sustain our supply base. In fact, as of last week, we had received approximately $55 million in accelerated payments from our customers and advanced almost $300 million to our suppliers on an accelerated basis. After all this, we ended the first quarter with a cash balance of $5.3 billion and a net debt position of $12.7 billion down slightly from this time last year. Our net interest expense in the quarter was $107 million down from $117 million in the first quarter of 2019 on a lower average outstanding commercial paper balance. But for the year, we're revising our interest forecast up to approximately $490 million to reflect the additional borrowing I discussed earlier. Q2 will be the peak interest expense for the year. As Phebe noted, we had ample liquidity including $5 billion in lines of credit which we renewed during the first quarter, and we expect the outstanding debt balance to come down over the next couple of quarters as we repay the $2.5 billion maturing in May as well as our commercial paper balance. On the capital deployment front, capital expenditures of $185 million in the quarter were consistent with the year ago. We expect CapEx for the year to be down somewhat from our original forecast as we manage that spend in light of the circumstances but still in the range of 2.5% of sales on a reduced sales number. In the quarter, we paid $295 million in dividends and spent $500 million on the repurchase of 3.4 million of our shares. This covers the dilution from stock option exercises that we were unable to address last year due to cash constraints plus the anticipated dilution for the current year. For the year, we now expect free cash flow to be in the range of 80% to 85% of net income versus the 85% to 90% we previously forecasted, reflecting the reductions in Gulfstream aircraft production and delivery rates, partially offset by the reduced capital expenditures, cost savings across the company, and somewhat lower cash taxes. Speaking of taxes, our effective tax rate was 16.7% for the quarter benefiting from several factors including lower international taxes and increased research and development tax credits. For the year, we're lowering our anticipated tax rate from 17.5% to 17%. As Phebe mentioned in her remarks, we finished the quarter with total backlog of $85.7 billion, that's up 24% over this time last year, and total potential contract value including options and IDIQ contracts was $124 billion, up 20% over the year-ago quarter. And just one last thought for you as you consider the quarterly progression throughout the year. Obviously, there's more uncertainty than we would normally have at this point in the year, but as you might expect, we anticipate the second quarter being the low point in EPS in the range of $0.25 to $0.30 below the first quarter with a steady ramp in the second half to achieve the updated targets that Phebe discussed. Howard, that concludes my remarks and I'll turn it back over to you for the Q&A.

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

Thank you. And our first question will come from Seth Seifman with JPMorgan. Please go ahead.

Hi. Good morning. Sorry I was on mute. So I realize this is probably very difficult given where we are in the unprecedented nature of the situation. I think the deliveries you talked about at Gulfstream this year coming out of backlog I think was probably fairly consistent with maybe where people thought and maybe even a bit better. As we look out beyond this year and we think about what might happen to the backlog as we move through the year and as you deliver out backlog, is there any way to kind of I don’t know if there is any way to bound that or maybe any way to talk about some of the distinct aspects of this pressure that Gulfstream is seeing now versus periods of pressure in the past?

So let me address that in two parts. Our reduction in production this year was driven most exclusively by disruptions in the supply chain. Some of our suppliers entered this crisis somewhat impaired both from exposure to the commercial aviation market and some financial difficulties. The crisis exacerbated that and even before they were hit, they were having some difficulty keeping up with our original production rate. So we took down production, which we believe helps de-risk the current environment and frankly de-risks some of 2021 if in fact we see weakening demand. But look, with respect to this year's production, you can only go as fast as your weakest link in your chain. So that's part one. Part two, which really I think is expanding a bit, is how we see demand in this environment. And as I think we alluded to, we fully expect business aviation to recover in due course. The question is specific timing, but this will again be a robust market for us and we will lead with a strong portfolio of new products. If you think about it, one of the outcomes that could occur as a result of this particular crisis is that businesses can ill afford to rely on those commercial airline providers who are either financially weak or unpredictable. So the fundamental case for business aviation remains the same, if not somewhat strengthened by this crisis, and frankly, I think there is a case to be made that demand for business aviation will increase as a result of this particular crisis. But there is an important reality I think for all of us to comprehend: in all markets up or down, we have the distinct advantage in product, service, and cost that leads the competition to compete only on price and availability.

The next question will come from Robert Stallard with Vertical Research. Please go ahead.

Phebe, I was wondering if you could comment on what you might have seen in the shorter cycle business jet off-the-market and the FBOs this quarter and partly in April as well, whether this could be a lead indicator of where the demand environment is going.

Sure, I think it's a particularly unusual environment in that it was worldwide and the fact that all human beings—not just particular sectors—were impacted. Hence the imposition of travel restrictions both in the United States and elsewhere really drove our flying hours down. So we saw a considerable decrease in the number of flying hours that we believe will resume when some of these travel restrictions begin to ease and people feel safer traveling. I'll tell you the loading at most of our service centers remains solid. We've implemented some rolling furloughs at a couple of our smaller sites; scheduling inspections and planned maintenance continue at a good pace, but some of the discretionary work, I think, referred for avionics upgrades has fallen back a bit. But again, once we resume normal flying activity, we anticipate that some of this will likewise resolve.

And the next question will come from George Shapiro with Shapiro Research.

One for Jason and then one for you, Phebe. The one for Jason, and maybe you mentioned it, but if you did, I missed it. If you can reconcile, you have in the back your gross orders and then if you just look at backlog, I guess that's a net number. Is the roughly $300 million difference primarily cancellations, which you gave the list in the back there, or what is it? And then for you Phebe, in terms of the expectation for deliveries for the year, I assume the second quarter is going to be a lot weaker than the rest of the year, and also where is the status of the EASA certification for the 600, thanks?

Okay. Well, we had four defaults in the quarter. A chunk of those were not for 2020 airplanes. Their customers we expect to see back. With respect to the second quarter, I think deliveries will be stronger, but as you can imagine with the reduction in production, we are taking costs out of our business and we'll have some charges around those, particularly in any of the risk charges in the moment, and so that could depress the second quarter a bit. But deliveries could be higher depending on how fast and in what sequence and in what areas these travel restrictions lift. It's very hard to gauge, because we need those travel restrictions to abate since people typically come to pick up their airplanes in Savannah, or we fly them elsewhere to effectuate a transfer, and that's extremely difficult in the current constrained environment. But as we see some of the rolling reopening both in the United States and outside the United States, we expect some of those deliveries to improve.

And our next question is from David Strauss with Barclays. Please go ahead.

Thanks. Good morning. Just Phebe, one on the implied Gulfstream decremental margins, I think you took down revenue by about $1.5 billion and your EBIT expectation by about $400 million, applying some more mid to high 20 decremental margins. How much of this is driven by just reduced productivity because of production issues, work-related issues, and supplier issues? The decremental margins are a bit higher than I thought we would see?

Some of that is based on efficiency, particularly as we learn to optimize operating in a CDC-driven environment, but some of it is also mix.

Okay. And then a follow-up on capital deployment. Obviously, you have the debt pay down here in May. You guys deal with commercial paper, but how are you thinking about share repurchases in the current environment given maybe political headwinds to doing that versus where your stock price currently sits, thanks?

I think you're quite right to point out the political concerns in the policy arena about stock buybacks, but from my perspective in periods of great uncertainty and volatility, maintaining your liquidity and the strength of your balance sheet is key. So we're going to stay away from stock repurchases at the moment.

Our next question comes from Carter Copeland with Melius Research. Please go ahead.

Phebe, I understand that each downturn or demand decline in aerospace has its own distinct characteristics. Could you provide some insight into what this particular situation is like based on your conversations with customers? I assume that most of your clients, particularly the Fortune 500 companies, are reviewing their spending on aircraft and their access to credit. How are those discussions taking shape, and how do you expect them to evolve regarding future purchases? Thank you.

So one of these elements that is distinctly different from the last time that we experienced in the 2008 timeframe, the Great Recession, was that interest remains very active, whereas in the previous recession, it simply stopped because of the impact on multiple key sectors. Here, it's really been about timing. How soon does the economy reopen, and how soon can we get travel restrictions lifted? So the conversations are continuing; that hasn’t stopped, but in terms of translating that activity into orders, some of that is going to take some time as we see how all of the reduction in travel restrictions and the stabilization in the economy occur. However, we see this more as a question of timing in this environment. As of the moment, the backlog is holding up very nicely, which results are distinctly different from the last time. But we're always mindful that if you have worldwide economic crises of the magnitude of these large economies, that backlog is an issue that we're going to have to follow very carefully, and we're being very mindful. This is a company that has been through this kind of environment before, albeit for very different reasons and manifesting itself in different ways.

And is it fair to characterize the decisions you will make from a production standpoint to get to the lower deliveries as temporary in nature, whether it's furloughs or timing related? I guess are you protecting upside in your production capacity for when things return to normal? Is that the right way to think about what you're doing?

I think the right way to think about it is that when you have changes in your environment, you have to react fairly quickly, postulating the best possible outcomes, and what we have done is, in the moment, sized our production so that our supply chain can keep up with it, but also recognizing that it prepares us if, in fact, demand does increasingly weaken next year to manage that risk as well. So I think we have found our risk as well as we possibly can in the moment, understanding what we see.

The next question comes from Cai von Rumohr with Cowen. Please go ahead.

Thank you very much. So the number of dealers we've talked to expect, as you indicate, the demand should pick up later in the year as the COVID impact abates, but one of the concerns they have is that basically there's been a weakening in terms of the pre-owned market. The pricing there is starting to erode and may go down, and in particular with the G650, where you have a large install base that pre-owned G650s would compete with your production. Are you seeing, or to what extent are you concerned about potential pricing pressures from the pre-owned market, thanks?

We have yet to see any. We don't see any significant buildup of pre-owned Gulfstreams, and we've seen no impact on price. That pre-owned inventory for each of our large cabin aircraft, including the 650, is well below the market standard threshold. So, at the moment, we neither have a lot of preowned inventory in our house, nor do we see that impacting our current demand, nor our current pricing. So this again is very different from what we saw in the 2008, 2009 timeframe. Pre-owned is simply not an issue at the moment.

Thanks so much, and one follow-up would be, can you give us an update on how you are doing with G500, G600 production and the expectation for certification of the G700 in late 2021?

So let's go in reverse order. The G700 continues to perform tests; its test pattern is solid. We have about 100 hours under our belt, and the airplane is performing extremely well. The G500 and G600, of course, are going to be some of the changes in the production that we have set for the year; some of the mix will change, but the demand for both of those programs has been wholesome and is increasing. And I think George asked the question that I failed to answer on EASA certification, and you teased that as well indirectly. EASA had been slowed by the impact of the MAX incident. And, while I can't speak to them directly in terms of their timing, this has no doubt impacted them as well, but we'll get through that. The more those airplanes are in the market, the more people see exactly what these airplanes can do for them, and they're pretty impressed.

The next question comes from Noah Poponak with Goldman Sachs. Please go ahead.

Phebe, is 100% of the Gulfstream delivery and revenue outlook reduction that you’ve made here today 100% from supply chain disruption and inability to fly to deliver airplanes, and none of it from demand impact?

Really, it isn’t demand-driven. I think I noted two factors a couple of times, but let me just reiterate: supply chain issues, but we also have some efficiency issues within these plants, within our assembly manufacturing plant, as we learn to optimize production under the social distancing rules, increased PPE, and the cleaning as we increase the number of shifts. So, as we begin to optimize that over time in our production environment, that will also allow us to mitigate any impacts from some of the inherent inefficiencies there, but that was also an issue. But overwhelmingly, the predominant issue here was the supply chain. And frankly, I said, if you think about it in terms of significantly weakening demand, we have done a nice job to de-risk some of 2021, and I think that's where you could potentially see demand and one of the salutary benefits of the actions that we're taking today is that they provide some risk mitigation for 2021. So, that's why I've said a couple of times, we believe that we've managed to mitigate our risk in all respects at the moment.

Have you seen any—not just through Q1 but year-to-date—any cancellations or deferrals in the existing backlog?

Yeah, I mentioned earlier that we had four cancellations, three of which we expect to see come back. But that is all we've seen to date, and our backlog continues to hold up very nicely. We recognize that this will de-risk any additional impacts to the backlog, but so far we're not hearing noise coming out of the customer base about the backlog of any note at the moment.

Our next question is from Ron Epstein with Bank of America. Please go ahead.

Maybe changing gears a little bit to your navy business, the navy has accelerated its procurement of systems. I mean if you talk to the procurement leadership in the navy, they will tell you how they're very proud of the amount of work they put under contract in a short period of time. How are you seeing that in your naval business, and how do you expect that to flow through the rest of the year?

So our navy procurement people have been really leaders and beacons of stability and foresight during this entire crisis. They have increased the velocity at which we've gotten contract awards; we particularly see that on the repair side. Our new ship construction is our larger contracts. I wouldn't expect to see any additional particular increase in velocity on those, but we have in the shorter cycle businesses, and they have been very, very supportive in understanding the need to undergird the defense industrial supply chain.

And then as one follow-on, you mentioned a couple of times in your prepared remarks and even in some of the questions that you’ve got some concerns over the supply chain. How do you see that playing out, particularly if you’ve got a smaller, let's call it a mom-and-pop supplier who is largely commercial aerospace, that doesn’t do much defense work, and they’re supplying into Gulfstream? How are you trying to mitigate that risk?

So if you can imagine, these are all sensitive negotiations. We're working closely with all our challenged suppliers at the moment, providing on-site mitigation and support where we can, and ultimately if we have to bring it in-house, we will. But we have managed through this and will continue to do so, but there is risk here. It's not without risk for reasons that I think you all can understand as well as we can.

Thank you. The next question comes from Jon Raviv with Citigroup. Please go ahead.

Turning to IT for a moment, any visibility or perspective on when we might see some of those nice backlog trends translate into growth when some of those items that you referred to might dissipate? And then also, can you talk about how IT is supporting the customer in the current environment and how it can be oriented to support new priorities coming out of the coronavirus crisis?

So one of the elements of GDIT is an enormous agility coupled with their customer intimacy. So as our customers adjust both on the defense intel and federal civilian environments, we'll work closely with them on new opportunities. I think one of the challenges is that our customers need to get back up and in a regular cadence and regular order, and that will then drive our ability to attend these sites. While many of our people can work from home, a lot of them have to be on site with the customer. Once the customer gets up to full operations, that will drive then additional revenue on our part. However, GDIT has been very successful in winning additional business that ultimately will translate into revenue, and profitable revenue at that. So, I think we need to particularly on IT get everybody back to work and then assess any timing issues from some incremental backed-up impact from the revenue side from this bit of a hiatus that some of our customers have taken. But they're positioned for good growth with their backlog. They have superb winning capture rates. So they fit very nicely and comfortably right now in their market space.

And just as a follow-up, can you talk about how customer conversations in that business might be developing in the current environment where there might be more focus on this aggregated workforce, further acceleration of the cloud, further IT monetization, and larger implementation of CDC, NIH type work packages? So any sort of thinking about how the national priorities might shift or accelerate coming out of this.

I don’t know that we have seen anything that one could realistically discern a trend from. I think it's too early. As far as the distributed workforce, I think that's premature. We have to look at the efficiency metrics on how that actually plays out, since many of our people need to be on customer sites. But we haven't seen a wholesale strategic or structural shift in the way that our customer is thinking about either the cloud or its mission in a post-COVID environment. I suspect naturally there will be some shifts. Again, as we think about how long do we keep social distancing, how long our rolling shifts remain in place. So some of that will play out, but so far I haven't seen a material structural change in how our customers are thinking about their mission.

And then we have one final question, operator.

And that question will come from Sheila Kahyaoglu with Jefferies. Please go ahead.

Jason, maybe this one is for you, given the free cash flow. Can you revisit some of the dynamics of the 85% to 90% conversion in 2020? It seems the Canadian payments are intact, so that's still about $1 billion. What are other changes to working capital, perhaps with either progress payments or inventories? Is it fair to assume that Gulfstream was maybe $500 million or so of inventories in Q1, given that you couldn’t deliver 11 aircraft?

Sure. I think you’ve picked up on a number of instant dynamics on a number of the drivers here. The $500 million payments on the Canadian program were inherent in our forecasts of those coming in, and that’s certainly welcome news to solidify that element of the outlook. When you think about the defense side of the business, some of the accelerated contract payments, progress payment rates have moved from 80% to 90%, and some other advance mechanisms we're seeing. As I mentioned, most if not all of that is essentially flowing through to the supply chain. So that's really sort of a net pass when it comes to the outlook. So bottom line, when you think about the overall impact, it really is at Gulfstream, and it's that portion of the production down. When you think about it, we were expecting to start this year with an inflection point on working through some of the inventory working capital at Gulfstream between the test airplane deliveries and getting 500 and 600 up to a more steady state production level. These production shifts sort of push that out, call it 6 to 12 months, and so the inflection point on that working capital drawdown at Gulfstream will just push out somewhat. So that's really the driver in the difference in the free cash flow conversion.

Thank you, Chad, and thank you everyone else for being on this call today. As a reminder, please refer to the General Dynamics' website for the first quarter earnings release and highlights presentation, which contains our summary outlook. If you have any additional questions, I can be reached at 703-876-3117. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your line.