Free 7-day Trial
All Articles and Columns »

General Dynamics Has an Appropriate Margin of Safety

August 06, 2012 | About:
Gabriel Canelli

Gabriel Canelli

9 followers
Overview: General Dynamics (GD) was formed in 1952 by the combination of Electric Boat Company, Consolidated Vultee (Convair) and several others. It is an aerospace and defense company that offers an extensive product and service portfolio regarding business aviation; combat vehicles, weapons systems and munitions; military and commercial shipbuilding; and communications and information technology. The main customer is the U.S. Government with about 70% of the sales, with the remainance split between U.S. commercial customers, Government and commercial clients throughout the world with primary subsidiary operations in Australia, Austria, Brazil, Canada, France, Germany, Italy, Mexico, Spain, Switzerland and UK. The annual revenues count with a value of US$32677 million and a net income of US$2526 million.

Market and Competition

Analyzing the company's competition is not an easy task. This is because its engagements to various businesses enclose the competition of different companies with each one. GD is a leader in each of its business, except for the aviation business because of the existence of competitors such as Northrop Grumman Corp., Boeing Co., and Lockheed Martin Corp., where the revenues of Lockheed are US$4.7 billion.

GD has cost advantages where operating margins are 12.2%. If comparing to competitors the average value is 10.5%. It is noted that this advantage is growing at an average value of 2% per annum. We can see the good performance of the company by their returns, to compare industrial companies we use return on invested capital, where GD has returns of 38% and the competition has an average of 29%.

The industry grew 4% annually in the last 10 years compared with the growth of PIB of 1.5%. GD has been growing the participation in the industry 48%. The competitor which follows is Lockheed with 25% of growth.

Financial health

GD has a debt on equity ratio of 30%. It is the lowest of the sector and has maintained the level in the last 10 years. Current ratio of 1.38 and liquidity ratio of 1.17 liquidity ratio, should be noted that the difference between the current assets and the current liabilities is greater than the total debt. Definitely we can say that this company has enough strength, either in the short or in the long term, to deal with any kind of crisis.

Performance

GD had no deficit in the last 10 years and increased the earnings per share 9.75% in each year, with an exception of the crisis of 08/09 when EPS was kept at $6.17 per share. We believe that this growth rate can be maintained or perhaps can slow down to a standard growth of 8%, which would not have an impact in obtaining adequate long-term returns. Sales grew 7.55% per year in the last 10 years. A good measure of creation value is the growth of the book value per share which was 8.46%, beating the S&P index (approximately 5%) in the last 10 years. To complement this information, free cash flow growth has been 7.86% per year and has been a very good control of the inventory which grew 4.13% per year, which is half of the sales growth. The company has been showing good control of the capital expenditures, reducing an average of 4% per year.

The invested capital grew 6.31% annually, compared with operating income growth of 8%. We can say that this company is efficient in their capital investment decisions because the returns were growing as fast as earnings, which confirms the good performance of the company and its directive.

Shareholder earnings

In the last 10 years GD paid to shareholders dividends of US$4295 million and US$4353 million of stock repurchase, or $46 for every dollar earned. Dividend yield at 63 cents per share is 3.23%, which overcomes the profitability of fixed income financial products of maximum safety (approximately 3%), and the dividend's growth of 9.96% per year.

In 2013 CEO Phebe Novakovic will assume the role of CEO, which we see as a favorable factor because of her knowledge of the company's activities from different perspectives. She has been working in the company since 2002, in strategic planning, manrine systems and at present as chief operating officer.

Valuation

With our model of discount cash flows with discount rate of 12%, the company has a value of $111 per share, but with this price we get a PE of 17.8 (five years earnings average). For this company we would pay a maximum of 15 times, which is a performance of the 6.67% of our investment, or $93 per share. At the current price of $63, we have a margin of safety of 32%. We chose PE 15 in this case because the performance of first-class bonds is approximately 3%. With 6.67% we doubled the profitability, which seems to us a margin of safety appropriate to invest in stocks. We can also compare the inflation of 2.5% with this return of 6.67%, where with the difference we overcome the performance of the fixed income financial product of maximum safety.

With the price of $63 we have a PE of 10.13, with normalized earnings of an average of five years. This is a return of 10%, which seems a more-than-acceptable price for GD. In conclusion, it should be noted that at this price we're getting a return 10.6% of the cash flow (five years average) overcoming the returns ratio cash flows of the S&P of 6.7%, which gives us good security to beat the market in the long term.

Risks

The main risk is in the fifth line of this article, and that is that the sales are concentrated in a single costumer (70% revenues). It depends on the U.S. government if the company continues to operate or not. But we believe that the product offered is particularly important to the government, especially for the economic and military situation, and the position of world power. Also, is important the competition between nations about military's power. We do not see reasons why the U.S. should be discouraged from investing $683 billion per year in this industry.

As a second risk, we can say that this kind of industries depends on their technological evolution to continue progressing and their need to continually renew their products to maintain or grow their market position. GD has the challenge of being at the forefront of the industry, and we believe this company has significant competitive advantages: costs, capital management and the experience, which is a key factor in this kind of industry that allows companies to be able to cope with any kind of setbacks, repair mistakes faster and focus the direction on the path of growth and evolution.

About the author:

Gabriel Canelli
I am from Uruguay and I am 24 years old, with an almost finished grade in the area of Economy. Since 2009, I specialize in value investing.

Rating: 4.1/5 (46 votes)

Comments

Zavala
Zavala - 1 year ago
Very interesting article, with a very thorough and professional analysis.
Bregan
Bregan - 1 year ago
"We do not see reasons why the U.S. should be discouraged from investing $683 billion per year in this industry."One quite obvious reason to consider would be that the U.S. simply can't afford to invest such a big portion of GDP to defense. The U.S has 41% share of global military expenditures. What happens to the fair value of General Dynamics in the case that US defense spending goes down significantly?

When you say that your 12% discount model gives you $130 fair value per share, what kind of growth rates are you assuming?

hschacht
Hschacht - 1 year ago
Did I miss a mention of the pension (hey that rhymes) liability? Isn't it substantial?

Put me down as being partial to NOC instead. Not that anyone asked ;-)

Pension liabilitiy near 0. Net debt near zero. Repurchased around 10% of outstanding stock in the last 12 months. Ridiculous fcf. I think $24 billion is fair value.
Gabriel Canelli
Gabriel Canelli premium member - 1 year ago
Bregan: I have to apologize. With my DCF model the company has a value of 111 per share and a PER of 17.8 with 5 years earnings average. I use the FCF growth rate of the last 10 years which is aprox 8% and 4% terminal value. About Government spending: We have to see how much it impacts on sales. We do not have to forget that GD is the leader of the industry, and the reduction may affect only the competition. But if the sales fall, the intrinsic value falls too. I think at price of 63 dollars per share GD has an strong margin of safety.

Haschacht: thanks for your input, but I dont think the free cash flow is ridiculous, you have to compare with the competition. All industries has differents margins.

In this kind industry which provides the government we have low margins. For example GD has a margin of cash flow (3 years average) of 8% which its substantially higher than LMT 6%, BA 4%, NOC 5%.
Cogitator99
Cogitator99 - 1 year ago
I think this analysis should include how much the government is expected to cut from defense, and how that will affect GD.

I like GD below 60, but I don't think it's worth 111. I'm not sure how your DCF got that, but that seems a bit much.

Keep in mind, over the past decade GD (and the defense industry in general) has enjoyed the tailwind of two wars (Iraq and Afghanistan). Are you expecting this tailwind to persist?

The other thing to thresh out is the value of the Gulfstream business, an important piece of the puzzle if you expect declining revenues from the government side.

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Hide