2.3 Financial HealthLiquidity
GD’s working capital management seems acceptable, with a current ratio of 1.3x as of June 2010. This ratio is in line with past performance, ranging between 1.1x and 1.3x over the last 10 years. While this ratio could appear low, it seems acceptable given the industry and the financial stability of the customers (the US government essentially) and the pre-order nature of the business with very high book/bill ratios.
General Dynamics’ cash conversion cycle has been going up in the last couple of years, shooting up to 97 days due to a large increase in days inventory. While this could be concerning, it turns out the increased inventory has now been moved with inventory having decreased back to historical levels as of June 2010.
GD carries very some debt with about $700M short-term debt and $3.2Bn debt for a total equal to about 1.6 times Free Cash Flow. Given the stable and very large backlog ($64B) I am not worried about this level of debt which at this point is almost healthy from an equity return standpoint!
In addition to its debt, GD carries a somewhat large unfunded pension and other retirement benefits liability for a current total of $3Bn, which we will have to add to the liabilities when we come to GD’s valuation
|$ millions, except per share data|
|Total Debt / Equity||0.4||0.3||0.2||0.3||0.3||0.3|
|ST % of Total Debt||15%||0%||24%||0%||0%||18%|
|Total Debt / FCF||1.9||1.6||1.1||1.2||1.3||1.6|
|Op. Income / Interest||18.6||16.8||23.8||27.5||23.0||29.4|
GD’s Altman z-score of 3.1 reflects its good credit position but also lower than usual current ratio and the somewhat asset intensive nature of the business, which we already saw in the ROE/ROA discussion. I am not concerned by GD’s Altman score - anything above 3.0x is perceived as good - even more so given the company’s good Piotroski score is 7, missing a ‘perfect score’ of 9 due to a slight decrease in net income on a TTM basis and a decrease in asset turnover from 1.08x to 1.02x.
In conclusion, GD is in a acceptable liquidity and credit positions. Given this strong situation, I will not increase my margin of safety requirement of 30%. Based on the stable, high backlog nature of the business, its entrenched position with the US government, and overall conservative B/S, I will use a cost of capital of 10% for our DCF valuation below and will deduct the $3Bn pension liability from the valuation.
2.4 Historic use of cashDividends, Buybacks and returns on retained earnings
GD pays a good dividend, yielding about 2.5% for investors, on a payout ratio of 20%-25% in recent years. In addition, GD has been recently more active in buying back shares – at a 2.5% p.a. rate over the last 3 years. As of December 2009, the company’s buyback plans still allowed for the repurchase of 9.4M shares, or about 2% of the outstanding shares. The company has been aggressively buying back shares in 2008, when the stock was at its lowest in years, providing good returns for investors and underscoring management’s foresight.
I am very comfortable with the current policy on dividend and what seem to be opportunistic buybacks, although a bit more dividend – pushing the yield towards 3.0% - would be great!
GD use of retained earnings has been satisfactory as the company has been able to gain good returns on its retained earnings. On a 5-year basis, GD retained $20.02 per share and increased its EPS by $3.12 over the same period, a 15.6% return. On a 10-year basis the return has also been good, at 14.2%
|$ millions, except per share data||Growth Rates|
|Dividends per Share||0.78||0.88||1.09||1.34||1.49||1.55||17%||19%||13%|
|Retained earnings per Share||2.83||3.68||3.99||4.83||4.68||4.70|
|Diluted Shares (M)|
|Note: Growth rates calculated using log-normal regression and exclude LTM|
3.1 Expected intrinsic returnsIn addition to a potential valuation benefit driven by the margin of safety (cf. below) returns for an investor will be driven by: dividends, growth and share buybacks / improvement in cash position.
GD currently pays a 2.5% dividend yield using 24% of its TTM earnings (or $1.55 per diluted share). In addition, GD will use about 30% of its earnings at 19% ROE to fund its estimated growth rate of 6%, leaving $2.72 for share buybacks/increase cash. At the current price of $53.7, GD could buy back up to 4.3% of its shares back!
Adding these returns together leads us to a total intrinsic return of 12.7% which is quite attractive!
3.2 DCFTo evaluate the value of the company I am relying on a discounting cash flow calculation with the following assumptions:
- 2011 Free Cash Flow of $2,432M (equal to TTM FCF, cf. Profitability and Growth section above)
- Growth for next 5 years: 6% (cf. above), declining to 4.5% years 6-10 and then 3.0% years 11-20
- Cost of capital: 10%
- Terminal value in year 20 with no growth
This leads to a DCF value of $36.9Bn for the company, before adjusting for net debt and pensions. Using a 30% margin of safety on this valuation leads to a per share entry price of $66.5, to which I am subtracting GD’s pension deficit (I am disregarding net debt as the company does not have cash in excess to debt and its debt position appears sustainable) leading to a price threshold for investment of slightly over $58.5.
I believe this evaluation of GD value to be conservative, using a “lower than trend” starting FCF as well as a lower than historical and analysts consensus growth rate.
GD’s is currently trading at about $63, slightly above the above entry point, however volatility could give the patient value investor a good opportunity in the coming months as exemplified by the company’s trading range over the last twelve month has been between $55 - $79.
4 ConclusionGeneral Dynamics is a strong company with little volatility, good historical and potential returns and little Balance Sheet risk. The current trading price is slightly above the calculated “entry point” valuation after applying a 30% margin of safety and deducting unfunded pension liabilities. But Mr. Market could well provide an opportunity to invest in the coming weeks.
Many happy returns!
Disclosure: I do own GD share which I bought a couple months back at~$61 and will hold on to them for the foreseeable future.