Free Cash Flow Conversion for Primes

FCF Conversion Tells You Whether EPS Is Cash

Defence primes report healthy GAAP earnings. The question for shareholders is how much of that translates to distributable cash after capex. FCF conversion (company-defined FCF ÷ net income) is the standard screen because percentage-of-completion revenue, contract working-capital swings and FAS/CAS adjustments, the gap between pension expense under US accounting rules (FAS) and the different figure used to price government contracts (CAS), routinely decouple EPS from cash.

Primes know this. General Dynamics weights FCF at 25% of annual incentive compensation in its 2026 proxy, alongside diluted EPS (25%) and operating margin (20%). If management is paid on FCF, equity analysts should not stop at P/E.

How FCF Is Defined

General Dynamics’ FY2025 10-K defines free cash flow as net cash from operating activities less capex. That is the company definition used across the peer set for conversion ratios:

FCF conversion = FCF ÷ GAAP net income

Operating cash flow can exceed net income while FCF conversion sits lower, because capex sits between the two. The distinction matters on every prime where OCF runs above 100% of earnings.

The GD Bridge: Where Cash and Earnings Split

General Dynamics is the cleanest filed example of the OCF-to-FCF gap:

Metric	FY2025	vs net earnings
Net earnings	$4.2B	100%
Operating cash flow	$5.1B	122%
Free cash flow	$4.0B	94%

The gap between the operating-cash line and the FCF line is capex, nothing more exotic. A prime that shows strong operating cash conversion alongside a lower, still-healthy FCF figure is not hiding a profit-quality problem. It is spending on the business between the two. Check the capex line first, before reaching for an earnings-quality explanation.

FY2025 Conversion Across the Peer Set

Filed FCF conversion across the six-name peer set:

Company	FCF	Net income	Conversion
L3Harris	$2.7B GAAP	$1.6B	170%
Lockheed Martin	$6.9B	$5.0B	138%
RTX	$7.9B	$6.7B	118%
General Dynamics	$4.0B	$4.2B	94%
BAE Systems	£2.2B	£2.3B underlying	92%
Northrop Grumman	$3.3B	$4.2B	79%

The range runs wide. Comms-heavy businesses with capex running below depreciation convert best; platform primes carrying heavier tooling spend sit lower. L3Harris’ own GAAP figure understates its cash generation slightly: adjusted FCF came in at $2,814M against the $2,736M GAAP number, a gap from stock-based compensation and acquisition costs typical of a serial acquirer.

House screen bands:

Band	Conversion	Action
Strong	>90%	Cash supports or exceeds earnings
Normal	70-90%	Typical long-cycle timing
Investigate	<70%	Working-capital or capex review

Why Conversion Exceeds 100%

Three forces push conversion above 100% at platform and systems primes:

Pension and FAS-CAS. Pension income or lower CAS contributions can inflate operating cash relative to segment operating profit. The effect varies by filer and year.

Working-capital timing on long-cycle contracts. Billings can precede revenue recognition on cost-type work, or lag on fixed-price milestones. A single quarter’s conversion can swing 20-30 points without a structural change.

Capex below depreciation. Mature programmes often run sustaining capex below the D&A charge embedded in net income, particularly at comms-heavy names like L3Harris.

L3Harris is the extreme case in this set: its GAAP net income materially understates the cash the business actually throws off. That is why an earnings multiple and a cash yield can read differently for the same company, the mechanism the valuation guide walks through.

Why Conversion Sits Below 90%

Northrop Grumman’s 79% is a useful case because it shows the mechanism rather than a problem. Net earnings of $4.2B exceeded FCF of $3.3B by roughly $875M, and on a pure defence prime with classified platform work, working-capital builds on new awards and capex on programme tooling can pull FCF below earnings in a strong order year.

Before treating sub-90% conversion as a red flag:

1. Check whether book-to-bill was above 1.0 (NOC ran 1.10x; orders can front-load working capital).
2. Compare OCF to net income (if OCF is also below 100%, the issue is broader than capex).
3. Look at pension/FAS-CAS in the cash-flow statement reconciliation.

Contract Mix Explains Part of the Spread

Cost-type contracts tend to convert cash more predictably because billings track allowable costs. Fixed-price milestones can bunch revenue recognition and cash collection in different periods. NOC’s portfolio is approximately half firm fixed-price; GD’s US government revenue is 51% fixed-price, 44% cost-reimbursement, 5% time-and-materials. The contract-type guide maps how mix drives segment margin dispersion; conversion follows the same contract mechanics on a lag.

L3Harris’ Communication Systems segment posts a 25.2% operating margin and sits at the top of this peer set on conversion. General Dynamics’ Combat Systems segment posts a lower 14.4% margin yet converts in the middle of the pack. Billing terms explain the gap better than margin does.

Using Conversion in Valuation

Conversion is an input to FCF yield, not a valuation metric in its own right. The workflow:

1. Compute conversion from filed FCF and net income.
2. Where conversion runs above 100% (Lockheed Martin, L3Harris), check FCF yield before leaning on trailing P/E alone; the earnings multiple is understating the cash the business generates.
3. Where conversion runs below 90%, don’t assume the cash yield is weak too. Yield depends on the price paid as well as the cash generated, so compute it separately rather than inferring it from the conversion ratio.
4. Where a company discloses FCF as a pay metric (General Dynamics weights it at 25%), that is a signal management is watching cash as closely as earnings.

The L3Harris profile is the top-of-ladder teaching case for this mechanic. General Dynamics shows the OCF-to-FCF bridge cleanly. Northrop Grumman sits at the bottom of the conversion ladder in this set, which is where the earnings-based and cash-based screens diverge most.