Erin Linnihan - General Dynamics Corp. Phebe N. Novakovic - General Dynamics Corp. Jason W. Aiken - General Dynamics Corp..

Ronald Jay Epstein - Bank of America Merrill Lynch David E. Strauss - UBS Securities LLC Cai von Rumohr - Cowen & Co. LLC Carter Copeland - Barclays Capital, Inc. Samuel J. Pearlstein - Wells Fargo Securities LLC Hunter K. Keay - Wolfe Research LLC Howard Alan Rubel - Jefferies Douglas Stuart Harned - Sanford C. Bernstein & Co.

LLC Myles Alexander Walton - Deutsche Bank Securities, Inc. Robert M. Spingarn - Credit Suisse Securities (USA) LLC (Broker) Jason Gursky - Citigroup Global Markets, Inc. (Broker).

Good day, ladies and gentlemen, and welcome to the Q3 2016 General Dynamics Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. As a reminder, today's conference is being recorded.

I would now like to turn the call over to Ms. Erin Linnihan, Staff Vice President of Investor Relations. Ma'am, you may begin..

Thank you, Chelsea, and good morning everyone. Welcome to the General Dynamics third 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..

Thanks, Erin. Good morning, all. As is apparent from our press release, we enjoyed another strong quarter. We reported EPS from continuing operations of $2.40 for fully diluted share on revenue of $7.73 billion and income from continuing operations of $767 million.

This is $0.20 per share better than the year-ago quarter and $0.10 per share better than consensus. Against the year-ago quarter, revenue was down $263 million or 3.3%. Operating earnings are up $35 million, a 3.4% increase, and income from continuing operations is up $34 million, a 4.6% increase.

This quarter's operating earnings of $1.07 billion reflect a 13.8% operating margin, 90 basis points better than the third quarter 2015. By the way, this is the eighth consecutive quarter that we've had both operating earnings and EBIT in excess of $1 billion. Sequentially, revenue is up $66 million, almost 1%.

Operating earnings are essentially flat and operating margin is down 20 basis points. On a year-to-date basis, revenue is off $540 million, a 2.3% decrease.

However, operating margins are up 50 basis points and earnings from continuing operations are up $54 million, a 2.5% increase, once again reflecting our emphasis on continuous improvement in operations. Earnings per share from continuing operations are up $0.57 or 8.5% over last year.

I should point out that the entirety of the year-to-date revenue decrease is attributable to Aerospace, as we forecasted in January. The defense businesses have actually shown some modest growth year-to-date. With respect to cash, we have $389 million of free cash flow from operations in the quarter.

That is 51% of net income from continuing operations. We have $1.1 billion year-to-date, 50% of net income from continuing operations. In the quarter, we repurchased 2.3 million shares for $348 million, offset in part by the exercise of 1.5 million options. We have purchased approximately 11.2 million shares year-to-date for about $1.5 billion.

This is consistent with our prior guidance that we would repurchase shares and pay dividends in amounts and somewhat in excess of this year's free cash flow, much as we did last year. As a reminder, in 2015, we had free cash flow of $1.9 billion and spent $4.1 billion on share repurchases and dividends.

This year, we have spent $2.2 billion on share repurchases and dividend year-to-date compared to a free cash flow of $1.1 billion, a delta of $1.1 billion. We will continue to use our balance sheet prudently and appropriately for the rest of the year.

In short, we are honoring our word in these two years of low cash flow and using our balance sheet to offset lower cash. As you can see from the charts attached to our press release, our very healthy backlog is holding nicely. Once again, there was good contract activity in all segments, with particularly strong order intake at Gulfstream.

We ended the quarter with a total backlog for the company of $62 billion, down modestly from the end of last quarter. Of that amount, $51.4 billion is funded. Let me say a few words about each of our groups. Let me start with Aerospace. Aerospace had another very good quarter.

Revenue is down $326 million or 13.9% compared to the third quarter of 2015, in line with the production cuts to the G450, G550 and, to a lesser extent, the G280, that we had previously discussed with you. Also remember that Q3 2015 was the group's highest ever revenue quarter.

On the other hand, operating earnings increased $11 million or 2.6% to $437 million on an operating margin of 21.7%, a 350 basis point improvement over the year-ago quarter. This is a real tribute to the operating efficiency of the Gulfstream and Jet Aviation teams.

By the way, this is the ninth consecutive quarter with operating earnings in excess of $400 million and the highest ever margin for the group. On a sequential basis, the group experienced $117 million reduction in revenue, 5.5%, but a $3 million improvement in operating earnings and 140 basis point improvement in margins.

On a year-to-date basis, revenue was down $571 million or 8.5%. Operating earnings are down $14 million or 1.1%, a 160 basis point improvement in operating margin. On the call last quarter, we advised that we were quite optimistic regarding order activity in the third quarter. Our optimism was well founded.

We had strong order intake in the quarter for the group, a 0.9:1 book-to-bill measure in dollar value of orders. Gulfstream alone was about 1:1 on a dollar value basis and 1.2:1 on a number of units basis. The distribution of these orders is also attractive, with the G650 and 650ER leading the way.

I can also tell you that our pipeline of prospects grew, and our active sales discussions are quite good. We are again reasonably optimistic about order intake in the fourth quarter and expect it to look much like the third quarter. By the way, this was the strongest discrete third quarter since 2011 for orders. Next, Combat Systems.

Combat had a very good quarter with revenue of $1.33 billion, operating earnings of $219 million and a really strong 16.5% operating margin. Compared to the third quarter of 2015, revenue is off $15 million but earnings are up $1 million on a 30 basis point improvement in margin.

On a sequential basis, revenue was up $15 million and operating earnings are flat. Year-to-date, revenue is down against 2015 by $198 million or 4.8%. Operating earnings are up $7 million or 1.1% on a 100 basis point improvement in operating margin.

Combat Systems remains on course for a very good year, and we fully anticipate that their fourth quarter earnings will see a 30% increase in revenue. All of our major programs are performing very well in Combat. Our cost performance has improved. Our competitiveness positions us well for the future and through rest of the year, by the way.

We continued to see opportunities for growth both internationally as allied nations continue to see increased emerging threats and domestically as the U.S. Army and Marine Corps begin to recapitalize their equipment. The Marine group reported revenue of $2.04 billion, a $44 million or 2.1% decrease compared to the year-ago quarter.

However, revenue was up sequentially by $56 million or 2.8%. Year-to-date, revenue has increased by $130 million or 2.2% to $6.2 billion. Operating earnings for the third quarter at $166 million are down by $15 million compared to last year's quarter.

The group's operating margins were down 60 basis in the quarter as a result of a onetime charge at Bath on their restart of the DDG 115 and DDG 116 program. This charge flows through to the sequential and year-to-date comparisons as well. IS&T, well, IS&T continues to outperform somewhat our revenue expectations.

Revenue of $2.34 billion is up $122 million or 5.5% against last year's quarter and up $112 million sequentially, also a 5% increase. Year-to-date revenue of $6.9 billion is up $99 million or 1.5% over last year.

Operating earnings of $256 million are up $37 million or 16.9% compared to the third quarter last year on the strength of a 100 basis point improvement in operating margin. Sequentially, the story is much the same. Operating earnings are up $12 million on a 10.9% operating margin in both quarter.

Year-to-date operating earnings are up $75 million, an 11.1% increase on a 90 basis point improvement in operating margin. This is a very good news story with both revenue and operating margins higher than expected. Really strong performance by IS&T.

So, what does all this mean as far as the year is concerned? Well, stronger than expected operating results in the quarter, a lower than planned tax rate and modestly lower share count enabled us to increase guidance for the year by $0.05. Our guidance for EPS from continuing operation goes from $9.70 to $9.75.

This late in the year, we anticipate our end of year guidance to be pretty close to actual performance. And finally in closing, as tempting as it is this time of year for some of you to ask about the following year, let me just remind you that we have a planning process in the fall when these businesses get better insight into the upcoming year.

That guidance, which we give to you in January, is grounded in that process and as a result, it's full and thorough. So, I don't want to prematurely piecemeal at this juncture. I would now like to turn the call over to our CFO, Jason Aiken..

Thank you, Phebe, and good morning. I'll be brief as I've got just a few things to cover before we start the Q&A period. First, some background on the charge in discontinued operations. Back in 2013, we settled the 1991 litigation with the U.S.

Navy related to the terminated A-12 aircraft contract in our former tactical military aircraft business, retiring in excess of $1 billion in potential risk to the company.

In connection with that settlement, we provided various forms of consideration to the Navy including the release of some rights to the potential reimbursement of costs that affected all ships under contract at the time at our main shipyard.

As we've progressed through the ship building process, we've determined that the cost associated with this settlement is greater than the parties anticipated. Therefore, we recognized an $84 million loss net of taxes to adjust the previously recognized settlement value.

As we've discussed throughout this year, we're seeing an impact on our financial results from foreign exchange rate volatility. It's still not material in the aggregate, but it continues to be a slight top line drag on some of our segments, particularly Combat Systems.

As Phebe pointed out, the group's revenue declined by 1.1% when compared to the third quarter of 2015 but had foreign exchange rates, particularly the U.S. dollar to the euro and the Canadian dollar held constant from 2015, the group's sales would have remained steady quarter-over-quarter.

Moving on to interest expense, the net expense in the quarter was $23 million, similar to the third quarter of 2015. For the full year, we expect net interest expense to be approximately $95 million. In July, we repaid $500 million of maturing debt with cash on hand and subsequently issued $1 billion of new debt in the quarter.

Despite the net increase in long term notes, our net debt position remains unchanged from the end of the second quarter at approximately $1.6 billion. We finished the quarter with a cash balance of $2.3 billion after deploying over $550 million in share repurchases and dividends in the quarter.

We funded our pension plan as expected in the quarter and continue to expect cash pension contributions for 2016 to approximate $200 million.

Our effective tax rate was 26.8% for the quarter, somewhat lower than we expected as a result of tax benefits from employee stock option exercises and other true-ups associated with the filing of our tax return. For the full year, we expect an effective tax rate in the high 28% range.

Erin, that concludes my remarks, and I'll turn it back over to you for the Q&A..

Thanks, Jason. As a quick reminder, we ask participants to ask only one question so that everyone has the chance to participate. If you have additional questions, please get back into the queue.

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

Certainly. And our first question comes from the line of Ron Epstein with Bank of America Merrill Lynch. Your line is now open..

Yeah. Good morning..

Hi..

So, Phebe, just a quick question. I know you don't want to get into much detail on 2017. But if I just rewind a little bit, I think in the past, you mentioned a goal, a longer-term goal of getting to double-digit earnings growth.

If we think about the margin performance that the company has done this year, how should we think – is double-digit a reasonable starting place for 2017 when we think about where earnings could go?.

Wow, so much for not getting into 2017. Look, we have, as a goal, double-digit growth, but it's too soon for me to tell how 2017 plays out. So, if you want to ask another question, go ahead..

Sure. Okay. So, thank you for that. So, maybe just a follow-up on – in the quarter, you mentioned that sales at Gulfstream were good, right? And you have book-to-bill of 1 or over 1, depending on how you want to measure it..

Order. Yeah..

Can you give maybe a little more color on kind of regional distribution and how G650 was doing? Because as you know, there has been worry about sales of G650s, that kind of thing..

Yeah. So look, you asked about the regional distribution, and I think it's worth stepping back a moment and talking in the general and then in the specific. And let's start by talking about the market, and let me try to give you some insight into our market. Let's start with, for example, the Honeywell study, which measures deliveries, not orders.

Deliveries in the business jet market are down, including somewhat at Gulfstream, right? So, the good and valid reasons that we have discussed during our transition, discussed with you previously during our transition from the G450 and G550 to G650 or G550 and G600 or G500 and G600.

Deliveries, however, are based on retrospective orders, so 12 to 24 months previously. And for Gulfstream, from an order perspective, we have seen and continue to see nice demands.

So, it would appear that we have been taking share from others in our space and as the G500 and G600 enter into service, we really anticipate that we will continue to take share.

I've been reluctant in the past year or so to get into a share discussion because we really are about – not about share but really about profit, but it would appear that we are indeed taking share. So, I think that understanding where we are positioned today and how our position going forward will help you.

It would also appear, specifically to your question, that we are far less dependent on the BRIC countries and on, frankly, any one particular region outside North America. And our demand, consequently, has not been as perturbative as others have seemed to be.

So, it gives you a sense of I think where we stand in the market and how we see it in general. Now, let's dig down a little bit deeper into Gulfstream, and let's just think about this.

So, from a Gulfstream perspective, again as measured by our sales pipeline and order activity with respect to demand, both are stable and sufficient to get us through to the new aircraft. I mentioned that the third quarter orders are the strongest in five years and interestingly, both our fourth quarter activity to date and the pipeline are good.

If we think about Gulfstream more specifically, let me talk to you and just give you a little bit of color without getting into guidance. This is just color in the most broad sense. The G500 will most certainly make a contribution in 2017 and a significant one in 2018.

The amount of the 2017 contribution, of course, will be dependent on the timeliness of the certification. The G600 should make a contribution in 2018 and a significant contribution in 2019. So, why am I confident in talking to you all about this? I'll tell you why. It's because the test program for both airplanes are going very well.

The G500 is doing well in tests and should be certified and entered into service in 2017, as implied by what we've just talked about. The G600 will fly this quarter and should be certified and enter into service, and all are on schedule with some forward bias.

Thinking about, again, just broadly, our market in Gulfstream in particular, I've always been of the view that a new plane needs 50 solid orders before the commencement of initial production to have a good start.

Well, the G500 is going to exceed that number, which is quite good, especially when you consider that our sales force has been incentivized to focus on the G450 and G550. They'll now be incentivized to turn their attention towards the G500. So, with respect to used airplanes, some of you have been very concerned about that.

Let me talk to you a little bit about where we are in the used market. We see, in the G650 market, I think there are about 19 to 20 airplanes that are up for sale, but as we deconstruct and analyze those potential aircrafts, we see maybe 12 to 14 serious sellers, dedicated sellers.

So, that's well within the 10% of the 200 and some – 203, actually, G650s that we've got into service, and we haven't seen any impact this quarter on our new order activity or our order activity from the used market.

And with respect to the G550, the used market is about 7% of the 700 or so aircraft in service and so, we haven't been affected by that either.

So, I notice that was rather a soliloquy, but I think your question about the distribution of our market I think was particularly just – gave me an opportunity to talk to you guys a little bit more fulsomely about the market. So, I hope that helped..

Yeah. That does. Thank you very much..

Thank you. And our next question comes from the line of David Strauss with UBS. Your line is now open..

Thank you. Phebe, I guess following up on that. You've talked about Gulfstream EBIT holding flat through this transition period.

Is that still the official line given the pull forward on the – it sounds like a bit of a pull forward on the G500 and G600 and with the G450 going out of production?.

Well, you're quite right. We said that we're going to try – we intended to keep earnings as flat as we could and the margins as high as we could during this transition period just to be a bit cyclical and frankly, so far, I think we've done a pretty good job.

We'll get into 2017 after we set our production rates and got a little more clarity into the market, but that still remains our goal to give you those higher earnings as we possibly can and margins as high as we can..

Okay. Quick, quick follow-up.

Marine – how much was the charge of Marine on the quarter?.

It's not material..

All right. Thank you..

But I wanted to mention it to you so you just at least understood what was going on..

Thank you..

Thank you. And our next question comes from the line of Cai von Rumohr with Cowen & Co. Your line is now open..

Yes. Thank you, Phebe, and congratulations. Terrific performance at Gulfstream..

Thanks, Cai..

Can you explain to me, I mean, for the deliveries that you made, which were pretty much in line where we were guessing, we had less profit by $30-million-plus.

So, was it lower R&D? Was it supplier payments? Was it forfeitures? Was it better margins? What got you to a number that strong and is that likely to repeat in the fourth quarter?.

Well, as we've talked before, Aerospace margins and Gulfstream, in particular, are variable quarter-over-quarter. But what you're seeing here is a result of the Gulfstream team doing a superb job taking costs out as their revenue has declined. And they've done a very good job at that in the quarter. R&D was somewhat lower.

We had some timing issues at Jet Aviation. I don't anticipate that performance going forward in margins, but they will continue to do quite well..

Okay. Thank you very much..

Thank you. And our next question comes from the line of Carter Copeland with Barclays. Your line is now open..

Hey. Good morning, Phebe and Jason..

Good morning..

Good morning..

Just a quick one on how you think about the transition to the G500, G600 from a margin or a cost standpoint, I guess. Clearly, it's come out that you'll end the G450 production in 2018, and you just made a comment about the contribution you expect from the G500 and G600 and how that layers in, in 2017 and 2018.

But with those aircraft being produced in different facilities, how should we think about the ramp down on the G450, and then eventually the G550 and how that impacts the overall cost structure of the segment? Thanks..

Okay. We've talked the last year or so about how we're going to manage the transition as we wind down the G450 and G550 and then bring on the G500 and G600. And the key there is matching the shipsets, the wings, the fuselage, the engines with the number of airplanes that we have left to sell or left to deliver.

And so far, with the G150 for example, we got it spot on. We're on track to get that perfect correlation on the G450 and I expect the same thing on the G550. So, I don't anticipate any decrease in margins as a result of our failure to make that transition really comfortable and profitable. That said, as we, look, think about it.

Any time you have a mix shift, which is what Gulfstream's going to have, right. You're going to have a mix shift as we go from older production, long-running lines, long historic learning curves, as we enter and start to produce and deliver G500s and G600s.

But I will tell you, if you look at the G650 by comparison, and let's just use that as our baseline, the G650 margin performance was faster and higher than the G550 before it. So, that means it's coming down its learning curve and we're seeing gross margin expansion earlier than we had ever before.

So, the lessons that we have learned on the G650, we are translating into how we go about the production on the G500 and G600, and that gives me an awful lot of confidence that this team is going hit the ground running.

They have some margin compression as we begin to deliver, as we come down those learning curves, but our ability to come down those learning curves as we've demonstrated, I believe is going to go much, much faster. And remember too, there's a fair amount of commonality between the G500 and G600.

So, I suspect that the ignition coming down, when we bring that G600 into full wave production, it's going to be pretty impressive. I got to tell you, I like where we are. I like where we're headed.

We're moving through this transition period like I told you we were going to do, and we're in good shape for real revenue and earnings growth as we get these two new airplanes into service..

Great. Thanks, Phebe..

Thank you. And our next question comes from the line of Sam Pearlstein with Wells Fargo. Your line is now open..

Good morning..

Hi, Sam..

Hi. I wanted to ask you about Combat Systems. You made a comment about the sequential growth you're going to see in the fourth quarter. And just to get to your annual guidance, you do need something like a 35% sequential increase.

So, can you talk a little bit about what drives that?.

Sure. So, the fourth quarter revenue increase is driven primarily by a couple of things. The Canadian, Mid East order and our AJAC programs as they move from engineering and low rate production in the third quarter into full rate production in the fourth quarter.

So you're going to see some real – and by the way, we got this – Combat has this analyzed down to a fine level of detail, and we have that growth in our backlog and we are positioned on both of those programs. So those are going to drive it primarily.

But recall also Combat tends to have very robust revenue growth in the fourth quarter across the portfolio, and we'll continue to see that in OTS and ELS as well as Land Systems. So, there isn't much ambiguity this late in the year with the group that really understands their products and how they're going to then begin to execute..

And if I can follow-up a question just in terms of the other Mid East Abrams order that Congress has been pushing back on.

Is there a certain timeframe when that has to come in until it starts to affect your production?.

Well, I'm not sure why you think they're pushing back on it. Frankly, they approved. If you're talking about the 100, in September, they approved the 133 M1A2 Saudi Main Battle Tank request, so that's good to go, it at contract..

Okay. Thank you..

All right..

Thank you. And our next question comes from the line of Hunter Keay with Wolfe Research. Your line is now open..

Hey, good morning. Thank you. Phebe, I'm curious about that comment you made about the sales force having their incentives change around the new programs slipping to the G500 and G600 from the G450, G550.

Can you help me understand a little bit how, first of all, when that happened? And how material of a change is this in their own lives? Is this like a significant driver of their compensation structure? Or is this a small thing in their bonus? I'm just kind of trying to think about ....

Well look, I'm not going to get into how we pay them..

No. I don't want to know how much money they make, but just....

But to give you a sense, just in general it's the case here is that the sales force is incentivized to sell whatever products we, at the moment, are focused on. And so their bonuses are a significant part of their compensation and it's up to us to give them the direction of where we're going have them focus.

So, this has been a very effective sales force as I think you can see from our order activity..

Oh, sure.

Did this change within the last few months? Or has this been in there for six, nine months, something like that? Or is it just like something a change effective at the end of the year?.

Well, look, think about it. The G450 we've announced – that line is going to end, surprisingly, right? These replacement aircrafts, by definition, are going to replace airplanes that we're winding down and the G550 has continued to have very nice order activity. So, we're pretty confident that it's time now to move more robustly to the G500.

And let me tell you, even incentivized as they were, as I mentioned in my remarks, we have sold quite a few. So, we're in pretty good shape here..

Thanks a lot..

Thank you. And our next question comes from the line of Howard Rubel with Jefferies. Your line is now open..

Hi, Howard..

Hi, Phebe. I'm so inclined to ask a Gulfstream question, but you've answered them all..

Oh, go ahead..

No. I won't do that. Instead, talk a little bit about Information Systems and Technology. I mean, you've stated that there has been a change and it's sort of taking on your growth profile.

Can you elaborate a little bit upon what some of the pillars are that are behind this and how you'd like to shape it going forward?.

All right. Let me kind of take that in two parts. And let's start with our book-to-bill because I think that that reflects a lot of different moving parts. In the quarter, we had a book-to-bill about 0.8:1, and that's solid for this short-cycle business.

And think about it in terms of the last eight quarters, or eight of the last 11 quarters for this group have had a 1:1 or greater book-to-bill, which is really quite exceptional in the short term for short, these highly transactional businesses. So, that gives us the platform for some of this ignition.

And in terms of where we're focused, on our platform side, we've got a number of growth opportunities across our platform portfolio. In our ISR business and space payload markets, cyber, nuclear weapons and avionics. So, I like where they are there.

On our IT side, we have had nice book-to-bills, and we've got a number of wins that we've had across the entirety of the portfolio. And I'll tell you, if you remember, we also have the census in there, which would be a nice cost plus award fee program for five years, and we like how that fits into our low risk cash generating portfolio.

And then going forward, we've got an awful lot of competitions coming up, and we tend to announce those as we win them or we put them into our backlog.

So, the diving board for our growth is there in our backlog, and because these businesses have really reduced their cost and increased their competitiveness, their book-to-bill has been wholesome for quite some time now and I expect it to be going forward..

And then actually, I do want to, as a follow-up, you know if you do the flight hours on the G500, you're clearly ahead of schedule.

Can you provide us a little bit of an indication of when you think in the first half of 2017 you might get the cert?.

I think first half is a touch ambitious, but I'll be able to give you in January a lot more clarity when we get the full certification timeline from the FAA. But I'm very confident we're going to cert in 2017..

Thank you..

Thank you. And our next question comes from the line of Doug Harned with Bernstein. Your line is now open..

Thank you. Good morning..

Hi, Doug..

I wanted to ask on Marine, on the Ohio Class Replacement Program, because the scale of that program is so large that one would expect it to transform Electric Boat in the next decade, and particularly if we see Virginia class stay stay at two per year..

That's my view..

So, when you look at it – can you talk about the general trajectory of revenues and earnings over the next five years as you move toward the first ship? And also, what investments might be needed to really set Electric Boat up for the scale of operations that will ultimately be there?.

All right. Let me give you a little bit – because this is such a big program, let me give you a little bit of detail on what's going on, on the Ohio Replacement. We have had the design contract now for about five years, and we're proceeding nicely apace.

As you know, we're the prime contractor for the design but not the sole contractor, and the prime contractor for the construction.

So, our schedule is right on point to start the conception of the lead ship in 2021, and I would imagine that – well, I expect that our profile on revenue between now and 2021 where we'll really begin to see the real ignition, will be driven by a couple of things.

One, we'll continue to have further design work on the Ohio, which will begin to ramp down as we get closer and closer. But starting perhaps in 2019 – I think we're anticipating 2019 – we're likely to see long lead production, so we can actualize the ship production construction in 2021.

So, as you know, these submarine programs take – require a fair amount of long lead material in order to ensure that you stay on your construction schedule. So, to give you a sense of where we in the design and the component development.

Well, we have proposed a detailed design and, actually, all the component development design to the Navy earlier this summer, and they'd like to give us an award by the end of the year.

And you know what, when you think about these large nationally strategic programs, one of the most important things that we all get right is that the costs are well understood. And so one of the things that's been driving our work the last three years is a bottom-up analysis of the full cost of construction.

So that'll be an important element as we work through those costs with the Navy. And once we get some clarity about the schedule and the pace, then we'll be able to have more clarity about specifics on that production ramp because it will all be very public and obvious..

When you look at Electric Boat though, this will really change what the operations look like up there.

I mean, how do you think about planning for that?.

Well look, I'm sorry, you did ask that, my fault. We have begun making the investments over the last five years.

The investments are primarily funded by the Navy, but we will also and have been putting some of our capital in and will continue to because, well look, we invest in lines of business that have high returns for us and good returns for us and this is one of those lines of business, and it is transformative.

You put Ohio on top of Virginia and there's going be quite a lot of workload. So we have spent the last five years both getting our facilities in place. Our design tools are mature. the design to build tools are also very mature, and we need to get our work force because we're going to have this increase in volume.

We're going to be bringing in a fair number of green labor. We have a robust education program in the trades with Rhode Island and Connecticut and that will provide us the foundation to really be able to start full rate production on schedule on the Ohio Replacement and continue on Virginia class.

Shipbuilding, one of the competitive advantages in shipbuilding is that detailed planning is critical, and that's something that Electric Boat has excelled at for decades and has demonstrated yet again in their preparation for the Ohio.

So we have detailed hiring plans, training plans, CapEx plans with the Navy, and of course our design work that we also have in lock step with the Navy on. So, this is all about preparing for success and so far, so good..

Okay. Great. Thanks..

Thank you. And our next question comes from the line of Myles Walton with Deutsche Bank. Your line is now open..

Thanks. Good morning..

Hi..

First one is a clarification. Phebe. I think you said that you were going to do repurchase and dividends slightly ahead of your free cash flow. I just wanted to clarify, and maybe I misunderstood. I thought previously it was the 100% of the net income and you kind of make up the difference for repurchase in cash flow..

So Myles, I think we've used a couple different terms in the past. We've talked about normalizing versus the lower free cash flow in these couple of years. But I think the key point is we had had a tremendous amount of cash on the balance sheet coming into the past couple years.

A lot of that was timing for a number of the things that we've talked about over the past several quarters. And at this point, the key is we are committed to using that balance sheet to again sort of normalizing that free cash flow at a lower level to return that capital..

And look, think about it this way, we've long been talking about these two years of fairly low cash flow. We need to normalize that cash flow and augment it by our balance sheet and we've done that.

I think about it more like, where are we in cash flow, where are we on the balance sheet, and what resources do we have to continue to go buy shares and other investments as needed. And I think we've managed that pretty prudently.

So I think about it as where our cash flow is and where are our cash deployment, where our cash flow is and what our balance sheet looks like and we've been pretty consistent..

Okay. And the conversion for 2016 you think can still get close to the 2015 conversion level at 65%..

We'll have to see on that. But we've got plenty of powder on our balance sheet. So, there's been no material change from the guidance that we gave you back in January about our cash flow..

Okay. All right. Thank you..

Think about it that way..

Thank you. And our next question comes from the line of Robert Spingarn with Credit Suisse. Your line is now open..

Good morning, Phebe, Jason..

Hi..

Hi..

Hi. On the cash flow, you've had this drawdown on the advances in Combat Systems on the large contracts you talked about before.

The Middle East lab and the AJACs and you've got the growth in Q4, but does that trend continue next year? Is there any concern that the Middle East customer might slow the intake of deliveries especially as those cash advances get exhausted and just given lower – the potentially scarcer resources over there?.

Well, let's talk about the Middle East for a moment in general. And this particular customer, we have had a 50-year productive relationship with the Kingdom.

And the vast preponderance of all of our combat programs are government-to-government and the contracts have been – products have been fully vetted and supported and these all happen to be products that the customer wants and needs.

So, we have seen no indication from the end-user customer that there is concern on their part or an intent on their part to change the profile of these – of our deliveries.

And look, we will – we got these large advances and we've been working those down and then we'll continue to refresh cash flow as we – from these customers as we increase deliveries. And so far, we're in pretty good shape..

Okay. And if I could just ask one more, Phebe, maybe for Jason, but a follow-up to Doug's question.

On this design release, on Columbia, Ohio Replacement that's upcoming, could – if the timing is there and the CR doesn't get in the way, could that be an inflow about $700-million-plus of design money to you by the end – before the end of the year or maybe early next year?.

Look, we will work with the Navy. I haven't planned on and haven't looked at the specific timing of the cash flow with respect to that order – of that contract, because we don't have the contract signed yet.

So, as soon as we get that contract, we'll have real clarity about the timing quarter-by-quarter of when we can expect the cash associated with that. But there's no way to estimate at the moment until that contract is signed..

Right. The reason I ask is because it sounds like DoD could be making some kind of decision in early November..

Well, they are. They're making their Milestone B decision, which is predicated on that submission that we just made on the components – detail design and component design. So, that is a trigger.

But once that decision is made, then you got a good contract, right?.

Fair enough. Fair enough. Thank you..

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

Certainly. And our last question comes from the line of Jason Gursky with Citi. Your line is now open..

Hey. Good morning. Phebe, just a quick clarification. I want to make sure I heard you correctly.

You said you have got 50 orders on the G500?.

No. What I said was that it has been my experience that you – to have a successful launch of a new airplane, you need to have 50 orders before entry into service and we on our way to exceed that amount..

Okay. That's helpful..

That helps?.

Yeah, it does. Thank you very much. And then, looking out to 2018, you suggested that the G500 will contribute in that year and then meaningfully – excuse me, in 2017 and meaningfully in 2018. You've also suggested in the past that you've got some delivery slots that are available on the G650 out there in the second quarter of 2018.

Just wondering if you could update us on that.

And what I'm trying to figure out here is whether you're going have enough in the orders on the G650 to hold production flat out there in 2018? Or if the plan here is to begin taking production rates down on that and having any hole from an EBIT perspective that gets created by the G650 decline and then filled in by the G500 and that's kind of the key to the recipe of holding EBIT flat through these transitions?.

Yeah. So look, what we said all along is that – we use that wonderful word feather – we'll feather in additional G650s. But that production rate during the transition is not sustainable nor healthy and that we would never intend to keep that production rate up.

What we aim for is to keep our backlog on G650s on any of our programs, particularly that one, between 18 months and two years and we're now at two years again.

So, as we think about that, I mean, that order book is there for the two – we've got now two years next available, so that ought to give you a little bit of color on how we intend to think through as we set our deliveries and our delivery schedule.

But I have not set, and we haven't set until later – late November or mid-November our production schedule for next year. So, on the fourth quarter call, I'll give you copious detail what we plan on doing.

Okay?.

Okay. Great. Thanks..

Thank you for joining our call today. If you have additional questions, Erin can be reached at 703-876-3583. Have a great day..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone have a great day..