1 Summary

In this analysis, I am looking at General Dynamics (GD, Financial) as a long investment opportunity. A stock review of GD’s financials attracted me to the company:

- Good cash flow generation

- High returns on equity, especially for a defense company,

- Somewhat low return on assets but still acceptable

- Good dividends and limited buybacks but overall a good potential for intrinsic returns

- Strong Balance Sheet

- Relatively low valuation on a cash return and P/E basis

The analysis will first evaluate the company’s performance which in turns informs a discounted Free Cash Flow model, coupled with the determination of a reasonable margin of safety and likely intrinsic returns of the company.

2 Company Analysis

2.1 Company overview

General Dynamics is one of the largest players in the US Aerospace and Defense sector (currently 4^th by market cap at $31B, behind Boeing, Lockheed Martin and Northrop Grumman). General dynamics derives ~70% of its revenues from US defense sales – the rest coming from foreign defense sales and Gulfstream jets - and plays in a number of areas, with activities in:

- Business aviation (16% of FY 2009 sales),

- Combat vehicles, weapons systems and munitions (30% of revenues in FY 2009),

- Shipbuilding design, repair and construction (20% of revenues in FY 2009), and

- Information systems, technologies and services (34% of revenues).

While General Dynamics is obviously exposed to the challenges posed by the likely decrease in US defense budget, the company is very entrenched and may not be the most exposed to the budget softness. GD provides some of the key platforms that are being used by the US army such as the M1 Abrams (army’s main tank) and the Virginia-class submarines. GD has a very tight relationship with the Defense department and both the Army and the Navy heavily depend on GD for some of their key battle equipments.

In addition, GD’s business aviation business should give it some upside in the coming years, coming from a couple of very difficult years for this industry. GD’s backlog stood at $64B or about two years of sales at the end of June 2009, with $18B in the business aviation line and $46B in defense.

Finally, over the years, GD has shown a good ability to execute relevant tuck-in acquisitions to keep expanding in strategic areas (GD spent ~$12B over the last 10 years), most notably in its IT business line, which I assume will remain part of GD’s strategy going forward.

2.2 Profitability and Growth

General Dynamics’ growth has been fairly high for the sector with averages of 10.7% and 13.5% over last 5 and 10 years, respectively. This growth has slowed in recent years, with the 3-year average being “only” 8.4%. This overall growth underscores the “health” of GD’s diversification as in recent years Aerospace and Combat System sales have been challenged but strong growth at the company’s Information System division helped the company keep growing well in a somewhat challenged environment. Overall, year over year growth rates have also been consistent, in the 8% to 13% range in the last 5 years.

With this consistent growth rate came also consistent operational and net income margins, with averages of 11.3% and 7.4% over the last 10 years, respectively and in line with performance over the last 12 months of 11.8% and 7.7%.

As a result Operating Cash Flow and Free cash Flow have grown consistently over the past 5 and 10 year periods. However in more recent years, OPC and FCF have been essentially flat driven by an increase in inventories (cf. financial health section). EPS on the other end has not been affected by the swings in inventories and has grown at a 10% clip over the past 3 years.



Looking forward, I will be using a conservative growth rate of “only” 6% over the next 5 years, which is below historical revenue performance of 8-10% on average over the last 5 years, and lower than what the company has experienced in any given year except for the last 12 months. This is also more conservative than analyst consensus of 8.5%.

Turning to cash flow and evaluating a “starting point” for our discounted cash flow (DCF) below, I will be using GD’s Trailing Twelve Month performance, which is slightly below the regression numbers over the 10, 5 and 3 year timeframes. Over the last 10 years, FCF growth has been extremely consistent with FCF’s volatility (standard deviation) being only 14% vs. the regression! This gives me good confidence in our starting point as we are taking a number somewhat lower than “normal”.

Turning to returns, GD’s ROE’s performance has been strong with returns consistently in the 17% to 20% range with a few better years. ROA on the other hand is a bit low for my taste (cf. my what I look for when reviewing a company) but I am ok with GD’s performance of 8% on average given that about a third of its assets are goodwill/intangibles…which reflect the acquisitions over time. In particular I am reassured that GD has been able to maintain its returns despite acquisition in recent years, meaning that they are able to get good returns on their acquisitions despite paying a premium for them. Based on this, I will be using the average of 19% for return on equity going forward as an input to the sustainable growth rate calculations.

Based on GD’s strong returns for its industry, good revenue growth cash generation and GD’s entrenched position with the Army and Navy, I believe that GD has a business moat. In addition, FCF has been very stable making me comfortable using a margin of safety of 30% in order to evaluate the attractiveness of the stock.

You can find more one-page “stock reviews” as well as more in-depth “stock analysis”, including copies of my financial model on my investment research blog: Margin of Safety Investing.


Many happy returns!

Ben

http://marginofsafetyinvesting.com