通用動力 (GD) 2013 Q2 法說會逐字稿

Good day ladies and gentlemen, and welcome to the second quarter 2013 General Dynamics earnings conference call.

My name is Laci, and I will be your coordinator for today.

At this time all participants are in listen-only mode.

We will facilitate a question-and-answer session towards the end of the presentation.

(Operator Instructions).

As a remainder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's conference, Erin Linnihan, Director of Investor Relations.

Please proceed.

Thank you Laci, and good morning, everyone.

Welcome to the General Dynamics second quarter conference call.

As always 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 and 10-Q filings.

With that I would like to turn the call over to our Chairman and Chief Executive Officer, Phebe Novakovic.

Good morning.

I am pleased to report that we had a strong quarter at General Dynamics with revenues of $7.9 billion and net income of $640 million.

We reported EPS of $1.81 per diluted share, $0.04 ahead of the year-ago quarter and $0.19 better than the prior quarter.

This was also $0.19 per share better than consensus.

Revenue for all practical purposes was the same as Q2 2012 and significantly higher than the prior quarter.

Revenue for each of our operating groups was higher than the year-ago quarter except for Combat Systems which reached a recent high watermark in the year-ago quarter.

On a sequential basis, Aerospace, IS&T and Marine were ahead of the first quarter.

Combat was essentially flat with Q1.

Operating margin was a strong 12.1% with good contribution and sequential improvement across all four of our groups.

Net earnings and earnings per share were ahead of both Q2 2012 and the prior quarter aided by lower interest expense and --- though somewhat offset lower share count in part by a higher tax rate for the quarter.

Let me turn briefly to the first half of 2013.

Revenues are down modestly against 2012.

However, net earnings are up over 1% and diluted earnings per share are up $0.09 or 2.7%.

In short, we're off to a good start ahead of our internal plan and ahead of external expectations.

With respect to cash, we had $486 million of free cash flow from operations in the quarter, about 76% of net income.

We had $915 million for the first half, still 76% of net income.

In Q2, we repurchased slightly over 6.6 million shares for $513.3 million.

Recall that in the first quarter, we had $70 million of purchases that cleared and was reported in Q2.

Similarly, we had $100 million of share repurchases in this quarter that cleared in early Q3 and will be reported in Q3 cash flow.

For purposes of discussion, if we include that $100 million I just mentioned, we have repurchased over 7.6 million shares for about $584.5 million in the first half.

In addition, if we had the Q2 dividend, you might recall that there was none in Q1 because it was paid in the fourth quarter of last year.

We have returned $782 million of the $915 million, over 85% of the free cash flow year to date to our shareholders.

Let's turn to the segment reporting for the quarter and for the half.

I also want to give you some general perspective on outlook for each segment for the remainder of the year, and then close with our EPS guidance for '13.

First, Aerospace.

Aerospace had a powerful quarter, with the highest revenue, operating earnings, and operating margins reported in the last six quarters.

We had good contribution from jet aviation and Gulfstream's performance was superb.

Just to provide you a bit of color, Gulfstream enjoyed a 170-basis-point improvement over the prior quarter in G-650 green manufacturing that more than offset a modest mix shift.

Also, our three large cabin models enjoyed a sequential 330-basis-point improvement in outfitted or completions margin, a clear indication of progress on G-650 completions.

For the first half of 2013 Aerospace revenues are up $616 million, or 19.2%.

Operating earnings are up $171 million, 32.4%, a clear manifestation of jet aviation's return to profitability, and the performance improvement at Gulfstream.

This is all reflected in 180-basis-point improvement operating margins for the first half of the year versus the first half of 2012.

This was really outstanding, but as I previously said we don't expect the third quarter to be this strong for three reasons.

First, we will experience cost increases on several G-450 and G-550 supply contracts which will compress margins.

Second, due largely to the vagaries of production planning we plan to produce two fewer large cabin aircraft in the third quarter.

Third we are delivering more green mid-cabin in the quarter resulting in a mix shift in deliveries of lower margin airplanes.

Our expectation in the fourth quarter is that we will return to Q2 production levels and improved learning on the G-650 line should offset somewhat the cost increases in the 450 and 550 supply chain.

Combat Systems.

Combat demonstrated the disciplined performance of a good cyclical, reporting 14.1% margins on revenue almost 28% lower than the year-ago quarter.

Land systems and OTS had particularly strong margins on cost reduction initiatives and program performance.

ELS was impacted by an additional restructuring charge of $18 million that was accelerated into the first half.

On a pro forma basis, that is not considering the restructuring charge, Combat operating margins were 20 basis points higher in the second quarter compared to the second quarter 2012, and 140 basis points better than the prior quarter.

All in all a strong performance in a tough market environment.

The story for the first half is much the same.

Revenues are off 23.6% against last year but operating earnings are down only 17.5% on 110 basis points of improved operating margins.

As I said, the performance of a good cyclical.

In the second half, we should see an increase in revenue and a boost to operating margins as ELS returns to profitability.

Its restructuring charges are complete.

Marine group.

Marine group revenues were higher than Q2 2012 in the prior quarter.

However, operating earnings and operating margins were down 2.7% and 100 basis points respectively.

Entirely as a result of the completion of the high-margin TAKE Program in 2012.

Nevertheless, operating earnings were up 11.9% sequentially, and operating margins at 10.1% were 30 basis points higher on good performance across each one of our businesses.

For the first half, Marine Group revenues are up $127 million, or almost 4%, and operating earnings are down $31 million, or 8.4%, solely attributable to the absence of TAKE profit.

In the second half we expect revenues to approach the first half.

Margin should be slightly lower.

IS&T.

IS&T is a good news story from a revenue perspective.

Revenues were higher this quarter than in the second quarter 2012 as well as the prior quarter in a tough market primarily with respect to our Army customer.

The revenues of each operating unit within the group improved sequentially.

Operating earnings and margins are down against second quarter 2012 by $28 million and 100 basis points respectively but up slightly against the prior quarter.

The operating result was driven by poor margins at C-4 systems, primarily attributable to the expenses in the UK business that is now embedded in C-4 systems.

We expect stronger C-4 margin performance in the second half.

The story is much the same for the first half.

Revenues are up $29 million, less than 1%, but operating earnings are down $61 million, 13.7% for the reasons I just noted.

For the remainder of the year, IS&T should see a little bit less revenue than we had in the first half with earnings up somewhat and a modest increase in operating margin.

Let me turn to our guidance for the remainder of 2013.

The guidance I gave you at the beginning of the year of $6.60 to $6.70 per diluted share did not include the impact of sequestration, if any.

The enactment of the 2013 bill went a long way towards stabilizing our program funding and mitigating some of the uncertainty for 2013.

Looking ahead to the remainder of the year, we are increasing our guidance to $6.85 to $6.95 of earnings per diluted share.

The lower end of the guidance anticipates our current understanding of the impacts of sequestration in 2013 and at [CR] for our fourth quarter.

If sequestration's impact this year becomes more Draconian than we can currently envision or if CR is implemented in a more rigid fashion than we can anticipate we will revise our estimate.

The upper end of the range anticipates that the impact on contract execution from furlough actions affecting our customers is mitigated as the year progresses.

So in summary, this guidance implies that EPS for the second half will be similar to the first half in a range between $3.42 to $3.52 per diluted share.

The fourth quarter should be the stronger of the two quarters.

I would now like to turn the mic over to Hugh Redd, our CFO.

Thank you, Phebe, and good morning, everyone.

Net interest expense was $18 million for the quarter versus $37 million in 2012.

For 2013 we expect net interest expense of approximately $85 million reflecting the full-year impact of our 2012 debt refinancing.

At the end of the quarter we had $151 million of net debt down about $460 million from year end.

The effective tax rate for the quarter was 32.1% and 31.5% for the six-month period.

For the full year, we expect an effective tax rate approaching 32%.

We expect cash contributions to our pension plans to approximate $600 million for 2013 with over half of that to be contributed in the third quarter.

Erin, that concludes my remarks.

Thanks, Hugh.

As a quick remainder we ask participants to ask only one question so that everyone has a chance to participate.

If you have additional questions please get back into the queue.

Laci, could you please remind participants how to enter the queue?

Thank you.

(Operator Instructions).

Jason Gursky with Citi.

Good morning, everyone.

Great.

I was wondering if you can just talk a little bit more about Gulfstream and the outlook for the demand, particularly in the mid range area and what you are seeing both domestically here from a demand perspective as well as internationally.

Sure.

Interestingly our book-to-bill was the same this quarter as the year ago quarter, and Gulfstream booked orders for each of our aircraft in the quarter.

80% of our large cabin orders were for 450's and 550 models.

So if you think about the half, about 50% of our orders on large cabin were 450 and 550.

We also increased sales of small to mid cabin aircraft over the first quarter and overall in the half orders increased 37% from a year ago.

The US market, by the way, led this order increase.

And I would say in general our order book is holding up very well.

I like where we are in our geographical distribution.

I like having some balance as a way to manage risk and mitigate over-exposure to one market.

So we're -- our funnel is robust, and we're turning interest into orders.

Okay.

That's great.

Thank you.

Carter Copeland with Barclays.

Hi, Phebe.

Hi, Hugh and Erin.

Just a quick question on the Aerospace margins and the impact you outlined in your prepared remarks.

Can you help us understand, one, just kind of the magnitude of how this is going to impact the margin rates in Q3, just in, I guess, general terms?

And then, two, give us some color on why it is that we have renegotiations that are taking the prices up with suppliers on programs that otherwise I would think are pretty mature?

It would seem somewhat odd to be negotiating prices up on really mature platforms.

Well, this seems to be an issue or a question that many of you have, but the fact of the matter is that on the 450/550, we have renegotiated a series of contracts, and in some instances, we are paying higher prices as material costs go up and labor goes up.

So we need to offset that through performance.

I think that that's basically the law of economics, as we think about our supplier base.

I will tell you that this is not a one-time payment, that the increase will last the life of the contract.

So as a result we do expect margin compression in the second half, and it will be partially offset as we -- in fact, wholly offset as we move forward and move down our learning curves.

Also, on both the 450, 550, 650, and 280.

I will tell you that the first quarter, first half performance and productivity in Aerospace was just superb and well above our expectations.

I did give you some granularity on what's happening with respect to the increases in supplier contracts on 450's and 550's.

We do plan, just because of the vagaries in production, to produce two fewer aircraft, large-cabin aircraft in the third quarter.

And we are going to grow our green aircraft deliveries in the third quarter for the mid cabin, which is going to cause a mild mix shift.

So as we come down our learning curve from 650 to 280 that pickup will offset in part the higher supplier costs on legacy cabin models.

While some of you may find it difficult to understand why it is that we have increasing prices, I will tell you that that's often the case despite the maturity of a program.

Costs do increase.

So is it safe to say that the margin rates we saw in Q1 and Q2 are both unattainable in either of the quarters in the back half?

Yes, I don't think we're going to -- we're not going to see those margins, for the same reason I explained.

Okay.

As we get the impact of some of these other changes.

All wholesome, by the way.

Yes.

Thanks, Phebe.

Doug Harned with Sanford Bernstein.

Thank you.

Phebe, I'm interested on the G-650, given the strength you're seeing with Gulfstream right now, how do you look at the production trajectory for that?

Do you see a place soon where you would start to take rate up to meet demand?

As you know we plan our production every year at the beginning of the year or late in the fourth quarter.

For '13 our production rate is set.

We will look at our '14 production rate later this year.

I will give you a little bit of color on a 650.

We look at our learning curves and productivity on each one of our airplanes every quarter.

And we had a significant improvement in green, and most importantly, completions margin in the second quarter on 650.

As Gulfstream worked through that disequilibrium I talked to you about before between initial and final phase production more quickly than we had anticipated.

If you think about it, as a result of working through that disequilibrium faster than we thought, we saw a step function improvement in our learning that's just not normal learning.

As we move forward we won't see that kind of learning on a steady state basis.

I hope that gives you some additional color.

But one thing I wondered is, in the past we've heard that you are sold out for roughly five years on the G-650 which seemed to imply at least some sort of a rate plan farther into the future.

I just wondered, given what you see in demand out there, if you're feeling the pressure to try and take that up, if you can handle it from an operational standpoint.

We will set our production rates based on our supply base, what we believe that we can produce effectively and the needs of our customers, and that's all I'm going to say.

For the remainder of this year, it's set, and we'll give you, at the end of this year, or beginning of next year, we'll give you some color on '14, okay?

Okay, very good.

Thanks.

Yair Reiner of Oppenheimer.

Great.

Thank you.

Congrats on the strong quarter.

Thank you.

A question about CS.

The revenue drop-off was quite substantial, and I think that probably steeper than we had anticipated.

Was there anything in the quarter that maybe didn't play out as you anticipated in terms of volume?

And then related question, you announced a rather large order from Germany for the EAGLEs.

Can you help us size that contract, maybe talk about how those vehicles are going to deliver?

Yes, let me explain our -- when I spoke to you on the fourth quarter call, my projections about revenue at Combat Systems were based on an anticipation of a series of large international orders that have slipped to the right.

I think that I have demonstrated my inability to be an accurate prognosticator of timing on international orders so I'm not going to walk back into that.

But I will tell you with respect to the international orders the circumstances that existed when we first talked to you about them are still [existent] today.

It's simply a slip to the right.

So as I think about Combat, clearly their first half is affected by the lack of these orders, and there are multiple orders slipping to the right and we have anticipated that they will come in, in the latter half of the year.

But as you would expect, the later they come in, the more of an impact they will have on revenue.

I would tell you, however, that we do not anticipate any material impact on their earnings, in Combat Systems earnings for the year as a result of that slip.

Thank you.

And with respect to the EAGLE contract with Germany?

Yes.

So we had a nice win there but the customer has asked us not to disclose the funding level so I don't intend to.

Okay.

Thank you.

Myles Walton with Deutsche Bank.

Thanks.

Good morning.

Good quarter.

Phebe, could you talk a bit about the margin potential at Gulfstream for the full year?

I know you had given the previous guidance and you kind of haven't updated that, other than to say it's going to be down the second half.

But I think the prior guidance was about 15.5%, 15.6%.

And likewise, as you look to the EPS guidance for the full year does that contemplate cash deployment in the second half in terms of share repurchase?

Answer your second question, no, does it not anticipate share repurchases.

And with respect to your first question, we are going to release our Q shortly after the call, and you will get more color on the segment by segment guidance.

Okay.

Thanks.

But suffice it to say we are going to be above in Aerospace, I would guess around 100 basis points.

Okay.

And cash flow for the year, the net income conversion, do you anticipate getting to a full net income conversion this year?

And if not, is it a temporal issue that goes back in '14?

We anticipate, given our current plan, a free cash flow of about 90% of net income and frankly, our cash will be determined by the timing of the large international orders.

But I factored those in, in the second half, and I'm looking at about 90%.

Could be higher.

Okay, got it.

Thanks.

(Operator Instructions).

Robert Spingarn with Credit Suisse.

Good morning, Phebe and Hugh.

Wanted to ask you about Combat Systems and understanding what you just said about prognosticating on international orders but let's talk about Abrams for a moment.

And if could you give us an update on how much longer your US funding lasts and where potential international orders can take that program, and how long major potential Middle East orders could sustain it.

So let me give you a little bit on Abrams.

We continue to see Congressional support coupled with our international sales as a bridge to Abrams modernization.

And that's really how you have to think about the tank line is that we are currently in a bridging scenario, where we will bring in international orders and maintain the lowest possible level of individual tank units.

To keep that line open, hold our industrial base viable and keep the talent in place.

So the bottom line is we're almost there bridging to the future.

We talked to -- I believe that the Abrams modernization is now a '16, '17 -- fiscal year '16, '17 event.

We're almost there.

We just need a little bit of help from Congress and the international orders.

I'll tell you something interesting, Congress for almost 30 years has been there to support America's Army in times of budgetary stress.

I have to tell you had they not done so in the past I shudder to think what the recent hot wars would have been like without the Abrams tank.

Phebe with the size of this potential order that's out there, very massive, in fact, couldn't you go above the minimum levels?

Clearly, yes we could, but I'm simply telling you what the strategy is.

We want to maintain the minimum levels as our baseline.

Then the more volume we get, the better it is for the workforce and the industrial base and we need to be there for when the US Army needs us again, and they will.

Just lastly, since it was your old segment, could you give us color on what happened with the DDG 51 award and how -- I think that went the opposite of the way it might have gone previously.

The lower bidder won five ships.

Bath won four with an option, so as you can imagine, we're very focused on our competitiveness at Bath, our cost structure and our build efficiency.

We intend to continue to improve our performance and drive our costs lower.

Because at the end of the day we need to provide stability for our workforce and the lowest ultimate cost of destroyers to our customers with the highest profit margins in our market.

And that is all achievable.

Thank you.

Joe Nadol with JPMorgan.

Hey, good morning, everyone.

So Phebe in the IS&T segment, which is still your largest segment by sales, things seem to be stabilizing quite a bit after a pretty tumultuous period last year, particularly in the second half.

Sales have stabilized.

Margins seem to have stabilized sequentially.

You are indicating margins are going to be up a bit in the second half.

Also backlog has stabilized.

Take a step back.

This used to be a 10%, 11% business for a very long period, and now we're down in the 8% range.

As things have stabilized, how do you view the opportunities going forward for getting margins back up to double digit?

We are, as you can imagine, restructuring our business, and let me give you, in order to maintain our profitability, and increase our profitability, but let me give you a little bit of color on what's really driving our IS&T at the moment.

Our book-to-bill for the group is 1 to 1. And frankly, this is, we've had six consecutive quarters of greater than 1 to 1, or close to 1 to 1 book-to-bill so it looks pretty stable to me.

You also may recall that at the beginning of the year we reset the plan for IS&T and we're focused on earnings and cash.

I expect to see the benefits of that accrue and partially toward the end of this year.

And then going forward we have some margin expansion opportunities across all of our businesses.

One of the things that's driving, I think, our market is that the decline in tactical communications seems to be behind us.

So we've got the revenues -- we've got revenue that's both stable and sustainable.

I would also note that for '13 we have sufficient backlog to support our outlook.

So going forward we are focused on taking costs out of our business, stabilizing our workforce, and we're holding our own in a tough -- in fact, we're more than holding our own in a tough environment.

But this is a margin improvement story over time.

So structurally, given the mix here, do you still think it is a realistic target ultimately?

Not talking short term, but ultimately, if mix doesn't change from here, to get back to that double digit?

It's certainly our objective.

One of the things that's constraining us right now is a restructuring that we're doing in our UK business.

And once we get through that, that will take some of the headwinds away, or remove some of the headwind that we're currently facing.

That's going to take us through the remainder of the year.

Okay, thank you.

Robert Stallard with Royal Bank of Canada.

Good morning.

Phebe, six months ago when you took the CEO role you set out a fairly firm view on acquisitions.

I was wondering if that has changed in any way and whether you see the potential for any acquisitions, particularly as we start to see the defense industry consolidating in this budget environment?

Let me talk to you about that just briefly.

I have consistently said that our focus this year is on operations, that I've got nothing and have had no targets on my radar screen and that M&A is not a focus for us this year.

That said, if we think conceptually about the future, think it makes sense to maintain a strong balance sheet with the budget uncertainty we are facing.

And as you quite rightly point out, we want to have the capability to be opportunistic with a strong balance sheet in an industry that is likely to experience some consolidation.

But the risk of being a broken record, I'm working on our operations, and I think that the team's results are obvious.

So I think that kind of tells you where we are.

Okay.

Thank you.

Sam Pearlstein with Wells Fargo.

Good morning.

Hi.

I guess related to that last question, you certainly have never really run the business with $3.7 billion worth of cash on the balance sheet.

So what is the right number in terms of the cash, and if you, in fact, are able to get to 90% of your net income, that's only going to grow.

So at what point does that cause to you either step up the buyback or start to think about external growth opportunities?

Well, again, through this year, I have told you and others that we expect to deploy almost all, if not all of our free cash flow to share repurchase and dividends.

Going forward, I have just explained the value proposition.

We'll continue to use our free cash flow in shareholder friendly ways, and maintain that strong balance sheet to give us flexibility.

I just think that's prudent.

It's prudent in two respects, because we believe we can grow this business by being smart in what we acquire, number one.

And number two, there's a fair amount of uncertainty.

So in a period of uncertainty, you need to keep your powder dry.

But that's not where we are this year, and when we get into next year, we'll begin to talk to you about how we see our positioning for next year.

But right now I got nothing on my radar screen, and we are really focused on our operations.

As you well know we had some work to do and this team is doing it.

Okay.

Thank you.

David Strauss with UBS.

Good morning.

Just wanted to circle back on Combat.

So we've been chasing this Combat down for the last several years, declining faster than guidance has been.

The business is now, you take the last two quarters, it's about a $6 billion run rate business from a sales perspective.

Just, Phebe, thinking about the international pipeline versus what's going on, on the domestic side, could this -- looking out over the next couple years could this drop below a $6 billion a year business in terms of revenues?

Let me be a little quarrelsome with you about the predicate embedded in part of your question.

We are not guiding you to revenue, and I think what I have tried to tell you is that we have to manage what we can control, and it's not revenue.

So our job is to be a good cyclical, particularly in Combat Systems.

That's to drive costs lower than revenue declines, and we're doing that and we will continue to do that.

Going forward, we have a sufficiently -- a very large and robust pipeline of international orders, and when they enter into our backlog will largely determine what the growth profile on the revenue side is.

But we are going to fight our margins.

And I think that's how you have to think about it.

Okay, thank you.

Cai von Rumohr with Cowen and Company.

Yes, thank you, and Phebe, great performance.

Very good.

Thank you.

So help me understand Gulfstream.

I mean, you've kind of said margins 16.5%, which implies a pretty big step-down in the third quarter.

How much is this supplier change?

For example, what percent of G-450 manufacturing costs do these contracts represent approximately, and does this new contract impact start beginning of the quarter, middle of the quarter, and so we can get some better understanding of how big a deal this is?

Well, I think I've given you all the color I plan to give you on the supplier contracts.

I've told you this is not a one-time payment, and I'm not going to parse the margin variances between the supply chain cost increases and our production rate decreases on our large cabin and the increases in our mid-cabin.

That's just not something we're going to report on.

But we will work our way through that.

And what I have tried to do is give you a sense that the first quarter was very, very strong, and we're going to see some margin compression in the third quarter, and fourth quarter we're going improve.

So just when you say you are going to be down two units in large biz jet, is that versus the 30 you did in this quarter or the 28 you did last year?

That is versus the first half.

You will be down -- I thought you said --.

In other words, in large cabin production in the second quarter, we're just -- because of the way our production planning goes, we are producing two fewer large cabins, and that is another factor impacting the margins in that quarter.

Okay, thank you.

Sure.

George Shapiro with Shapiro Research.

Good morning.

Phebe, I want to go look at this Gulfstream a little different.

In the second quarter, you had 29% incremental margins year-over-year, and the same sequentially.

How much of that do you think is due to kind of what you talked about as your one-time step down?

So what would be a sustainable kind of incremental margin?

And I've got a second one.

If you looked at just the 450 and 550 in terms of its book-to-bill in the quarter, was it about one, similar to the first quarter?

Thanks.

Look, our 450 and 550 orders are very strong, as I told you.

That's about 80% of our large cabin orders and for the half, about 50% of our orders.

So those two lines are holding up very, very well.

You asked about the incremental margin.

As I explained to you in the fourth quarter call, we had this buildup in working capital of green airplanes that we had to push through the snake, this bubble we had to push through the snake of completions, and we devoted an awful lot of resources to fixing that problem, and frankly we fixed it much faster than we anticipated.

Hence my comment about the step function improvement in margins.

I don't think it's prudent to kind of prematurely pinpoint what our gross margins on any of our airplanes are going to be going forward, particularly the 650, it seems to be of great interest, or when they will achieve it.

But we'll continue to come down that learning curve both in the green production, and most importantly, from my perspective, in completions.

We don't have enough experience yet to know what a running rate, a steady state running rate is going to look like on completions on 650s, but we've made a step function improvement, and I'm very proud of the Gulfstream team for working through what was a difficult operational challenge.

But I would think that the incrementals would at least be something north of 20%.

They wouldn't maybe be 29%.

Is that a fair statement?

George, I'm just not going to get into the variances with you.

I think at the end of the day -- I'm sorry, but at the end of the day, just take a look at where our -- I've explained the big muscle movements and where our performance has been and where it's likely to go, but Gulfstream is poised to continue to do very well.

And this is like almost all of our businesses.

We continue to learn, unit over unit, and that's important to maintaining your profitability.

That's just operating leverage, and I like it.

Well, you've always done a good job there.

Thanks.

Thanks.

Peter Arment with Sterne Agee.

Thanks.

Good morning, Phebe, Hugh.

Question on -- my question really is on Aerospace on the services side.

Phebe, could you just give us some more color on what you're seeing in terms of the overall services environment, both North America and also just thinking about the jet aviation business, how that is performing and what you are seeing on an international basis there?

Thank you.

Yes.

Let me take your -- you've got two questions just embedded.

First, let me talk about services, then I want to give you guys a little bit more detail on jet.

Our service revenue was technically down year-over-year because we sold, as you may recall, several underperforming jet facilities late last year.

But with respect to jet, their second quarter was better than their first quarter in services, and the third quarter so far is also improving.

Service activity was particularly strong in the quarter for Gulfstream, which posted its -- interestingly, its second highest service revenue quarter in the last six quarters, and the third quarter looks pretty good, too.

That's particularly noteworthy since we had secunded service staff to the completions challenge on the 650.

So very, very strong performance.

I would also point out that earnings on service increased a bit over the prior year quarter, and in the first half over the first half of 2012 on lower volume.

So I like where we are.

Let me give you a little bit more details on jet, because this is a good news story.

Jet was profitable in both Q1 and Q2 of this year, and each line of their business was profitable, and we expect it to remain so going forward, and I thought I might give you some detail on jet's lines of business.

Their FBO business is at the high end of its market.

Service business as you well know is volume driven but jet has good margins compared to its competition, particularly for not being an OEM.

But the potentially high-margin business is completions where we have struggled for some time on our operations, particularly in the high value added wide body completions market.

So we have devoted a lot of our sales activity and orders and completions have picked up.

So more to come on jet.

They've turned the corner, and they were a nice contributor in both Q1 and Q2 to Aerospace, and I anticipate that they will be for the remainder of the year.

That's great color.

Thanks.

Congrats on the quarter.

Thank you.

Bill Loomis with Stifel.

Hi, thank you.

Good morning, Phebe.

On IS&T it's certainly done well considering the environment, but can you kind of break it down as best as you can?

You mentioned that tactical products continue to be firm and appear to have bottomed out.

So if you -- can you give us some direction on what type of growth you are seeing and kind of outlook for each of the major parts, whether it's -- however you wish to break it up, tactical products versus IT services versus ISR, just so we can understand the three major moving parts there?

Sure.

Yes.

So our IT services business is just under 50% of our revenue, and they're seeing some really nice revenue increases, both in their defense businesses, their Fed SIV exposure, and their commercial markets.

Our ISR business is continuing to grow slowly, and they had a very good quarter for margins.

Our tactical communications business was the one that -- the one line of business that we have that was particularly affected by its exposure to the Army, but as I mentioned that has stabilized.

That can be a very strong margin performer.

As they restructure and embed the UK business into their business, they've got some upside.

I will tell you, though, again, that the backlog is there in each one of those three lines of business to support our outlook for the year.

And Laci, I think we have time for one more question.

Howard Rubel with Jefferies.

Good morning, Phebe.

How are you?

The -- I want to talk about risk, because I think you have been consistently talking about managing it and trying to eliminate it where you can.

Sort of two questions related to that.

One is, do you have -- can you talk about any red programs and/or the process you go about in terms of eliminating them or removing them?

And then second, as you sort of think about this plan that you have articulated for restructuring the business, how much of it is going to be a way of life going forward and how much of it is there's some big milestones and we've accomplished some things and you can feel satisfied when '13 is over?

I don't think that a high performing business is ever done trying to improve itself or shoot for additional operational excellence.

So I anticipate that we will continue to look for ways that we can improve our profitability, and frankly provide low-cost products to our customer.

Which in a declining market, revenue environment can be sort of challenging.

With respect to any consolidations, we did announce the consolidation of our OTS and ATP businesses.

You didn't ask this question but I think it's important to understand our margin story for the year.

We will cover those consolidation costs with realized savings in this year with no material impact.

What that does for us is position us nicely going forward for additional margin expansion.

Recall that this is a fairly easy business to -- relatively easy business to integrate, given that they've got a number of complementary programs, and in several cases the same customers.

So I think that that made a lot -- that was a logical thing to do as we were going through our operational reviews, and we're looking to improve our profitability and service our customer.

It was a logical outcome.

You talked about -- let me just mention one other thing, too.

As I noted several times or alluded to, we did restructure our UK business, and I think that was important to ensure that we can continue to meet the needs of our UK customer.

So we're well on our way to doing that.

And, of course, all of these restructurings are difficult.

You asked a question about risks, and I think I have given you, over time, a pretty good sense of how I see the risks overall.

But we have no material red programs.

We have programs that we would like to have perform a little bit better, but our business units know what they are.

I think the best -- I think that we talked about this on the last call.

The best antidote to a budget cut is performance.

I would note that bears eat the sick and the young first, so we are very focused on maintaining our good execution on each of our programs, because without that execution, you become more vulnerable.

So with a $31 billion business, and literally thousands of contracts, you are likely to have a few that aren't performing up to expectation, but there are none that are a red program.

Thank you very much.

Okay?

Yes, that's great.

Thank you for joining our call today.

If you have additional questions I can be reached at 703-876-3583.

Have a great day.

Thank you for your participation in today's conference.

This concludes the presentation.

You may all disconnect.

Good day, everyone.