While Warren Buffett often shares tips and wisdom on the kinds of companies investors should look for, in July he came out and named three companies he considered as potential purchases for Berkshire Hathaway. One company the rarely-wrong investor has his eye on is General Dynamics (NYSE:GD), which ranks high on the list of characteristics he looks for: simple businesses he understands, with economic moat, predictable and proven earnings, and can be bought at a reasonable price. But political developments threaten to disrupt all of that.
Founded in 1952 through a merger of several other businesses, General Dynamics has become a leader in the marine, aerospace, defense, communications and electronics industries. It is a less simple one than most of Buffett’s others. It operates in four business groups: aerospace, combat systems, information systems and technology and marine systems.
The business does fit into Buffett’s penchant for transportation businesses, though – it has a business aviation segment that operates the Gulfstream brand, the hottest jet in corporation aviation. Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) owns similar aviation companies such as NetJets and FlightSafety International.
In addition, he owned 14.1% of the company in 1992. Management was then a significant draw for Buffett, though the reins have since changed hands. In his 1992 shareholder letter, Buffett wrote:
We were lucky in our General Dynamics purchase. I had paid little attention to the company until last summer, when it announced it would repurchase about 30% of its shares by way of a Dutch tender. Seeing an arbitrage opportunity, I began buying the stock for Berkshire, expecting to tender our holdings for a small profit. We've made the same sort of commitment perhaps a half- dozen times in the last few years, reaping decent rates of return for the short periods our money has been tied up.
But then I began studying the company and the accomplishments of Bill Anders in the brief time he'd been CEO. And what I saw made my eyes pop: Bill had a clearly articulated and rational strategy; he had been focused and imbued with a sense of urgency in carrying it out; and the results were truly remarkable.
In short order, I dumped my arbitrage thoughts and decided that Berkshire should become a long-term investor with Bill. We were helped in gaining a large position by the fact that a tender greatly swells the volume of trading in a stock. In a one-month period, we were able to purchase 14% of the General Dynamics shares that remained outstanding after the tender was completed.
The U.S. spent approximately $698 billion on defense in 2010. In 2009, 2008 and 2007 General Dynamics was the fifth largest defense contractor to the U.S. government, with arms sales being 78% of its total sales. The largest contributor to its moat is simply that the country will always need a military.
The company also has the sheer range of its products portfolio and number of sectors it serves that makes it a go-to business for a diverse range of clients. It is also benefiting from ever-increasing emerging market customer interest. Its Gulfstream jet already has a strong brand, and Asian Pacific companies represented nearly 50% of its order book in the second quarter of 2011.
Further setting it apart is its dedication to product support and its service business. In the second quarter, Gulfstream product support was voted No. 1 for the ninth consecutive year in the annual Aviation International News product survey.
Last, its operating margin has remained stable for years, an indicator of wide economic moat:
Predictable and proven earnings
General Dynamics has generated 14.9% 10-year free cash flow growth and 12.6% 10-year revenue growth. From 2009-2010, it improved both its return on equity and return on assets.
Earnings are fairly predictable for the company as backlogs in the industry can run several years. GuruFocus gives General Dynamics the business predictability rank of 4.5 stars.
General Dynamics is selling at the lower end of its historical multiples. It currently trades at 9.3 times earnings, lower than the industry average of 11.5.
P/S is also in its lower range since the financial crisis at 0.7.
Ten-year P/B is near historical lows at 1.7, but higher than its two nearest competitors, Northrop Grumman (NYSE:NOC) and Ceradyne (CRDN). However, it is lower than the industry average of 2.5.
Though a profitable company integral to the nation’s existence, CEO Jay Johnson acknowledged at the end of his third-quarter conference call that it is facing the threat of federal defense spending cuts. But he believes “persistent global threats, election year politics, defense industrial base consequences and outlays from existing budgets must mitigate significant declines.”
The most imminent threat stems from congressional “super committee” members currently looking for areas of the budget to scale back on – which includes defense. If the Republicans and Democrats on the super committee fail to pass a proposal, there will be automatic cuts to the Pentagon budget of $500 billion over 10 years, in addition to the $469 billion in cuts already planned.
Some believe cuts to the defense budget is the logical option, as it remains massively inflated from before the war against terror began following 9-11. Others argue that pouring money into defense is vital for the nation’s safety.
Johnson says they are focusing on the things they can control under the circumstances, which he believes places them in a good position no matter what. Though nobody knows what will happen to the defense budget, one thing is certain, that Buffett has not bought the stock yet.
General Dynamics is one of the stocks in GuruFocus’ Buffett Munger Screener which finds stocks the younger Buffett and Munger might have picked. The connection was noted in a recent Fortune article about GuruFocus. Read about it here.