I) The Record
General Dynamics had a rich history of value creation when a CEO who was a good capital allocator was at the helm. This is a testament to the competitive advantages and quality of the underlying business. A dollar invested when Bill Anders took the helm in 1991 would have been worth $30 17 years later in 2007.
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Increasing per-share intrinsic value is more important for shareholders than increasing the revenue of the company at any cost. Bill Anders and then James Mellor shrunk the size of the company from 1990 to 1997 by shedding non-core assets and focused on business units with greater profitability and margin expansion. They also repurchased a large number of shares when the stock was trading under intrinsic value.
Nick Chabraja followed a different strategy which focused on increasing revenue and growth. He purchased Gulfstream in 1999 using the overvalued stock as currency. He sold shares equaling one-third of the company to purchase a business that provided half of the consolidated cash flow. He also was an aggressive repurchaser of stock when trading at significant discount to intrinsic value.
The tenure of Jay Johnson was not as fruitful for shareholders, and the acquisitions over the last five years have not turned out as well. The company took a $2.87 billion write-down during fourth quarter 2012, most of which was for $2.0 billion impairment in the valuation of the Information Systems and Technology division. The General Dynamics board had elevated Phoebe Novakovic to president and chief operating officer in May 2012 and she ultimately took over as CEO and chairman of the board on Jan. 1, 2013. It is looking based on initial pronouncements, candor and asset impairment decisions that she will be bringing the company back on track in terms of capital allocation decisions in-line with her predecessors Bill Anders, James Mellor and Nick Chabraja and focus on diligent business execution to achieve margin expansion.
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II) Business and History
General Dynamics has a long and illustrious history dating back to 1896. The following is the information from the company website.
“General Dynamics is a market leader in business aviation; combat vehicles, weapons systems and munitions; shipbuilding and marine systems; and mission-critical information systems and technology. The company was formed in 1952 through the combination of the Electric Boat Company, Consolidated Vultee (CONVAIR) and several others. The company grew organically and through acquisitions until the early 1990s, when we sold many of our defense-related businesses. Starting in the mid-1990s, we began expanding by acquiring combat vehicle-related businesses, additional shipyards, information-technology product and service companies and Gulfstream Aerospace Corporation. Since then we have acquired and integrated more than 60 businesses, including six in 2011. Our revenue has grown from $4 billion to approximately $32 billion in that time and our workforce has increased from 29,000 to approximately 95,000 employees today.”
III) Operations and Competitive Advantages
Morningstar Analyst Neal Dihora puts it well when he writes, ”General Dynamics products range from tanks to submarines to information technology to business jets. The company operates under a decentralized structure with four reporting segments: (1) Aerospace (22% of 2012 sales), (2) Combat (26%), (3) Marine (21%), and (4) Information Systems and Technology, or IS&T (31%). A diversified offering with key platforms that ensure the superiority of the armed forces puts the company in an enviable position in a time of budget strains around the world. Though we think defense spending will ease in the coming years, an entrenched product range, a robust aerospace business, and an operational focus will power the firm's return on invested capital well above its cost of capital for years to come.”
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These are some of the competitive advantages:
(1) Entrenched position in the U.S. armed forces and navy. There is an existing backlog that will last for two years and maintenance contracts will be a continuing source of earnings thereafter. It is impossible for this work to be outsourced to China!
(2) The start-up costs of getting into the business of producing “business jets” or “nuclear submarines” is prohibitive. This makes it unlikely for a new competitor to emerge and even more difficult to succeed.
(3) General Dynamics' business jets division, Gulfstream, has 60% market share globally and also has service locations all over the world.
(4) The company has a long history of innovation and holds many patents. Some of these can be used by the company to diversify into non-defense businesses.
IV) Balance Sheet and Profitability
General Dynamics has one of the best balance sheets in the defense sector and also compares favorably when compared with businesses in the manufacturing and industrial sector. The company has $4 billion of debt which is offset by $3.3 billion of cash. The prolonged low interest rates have increased the pension funding gap to $4.9 billion. The average cash generated from operating activities on average over last five years is $3.0 billion per year. The debt/equity of 34% is well within reasonable range and provides ample flexibility.
I believe increased focus on operations, focus on reducing cost and reducing excess working capital leading to margin expansion has the potential to push the per-share earnings significantly over the next three to five years. The Gulfstream business jets division is expected to grow by 10% to 15% per year over the next few years and offset any softness in other divisions due to defense cutbacks.
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Phebe Novakovic who has taken over as CEO from Jan. 1, 2013, after being elevated to president and COO in May 2012 has been with General Dynamics since 2000. She rose among the ranks to become the head of the shipbuilding unit which under her generated strong results. Novakovic was a CIA operative until the mid-1990s and a senior Pentagon official until 1999 when Nick Chabraja enticed Novakovic away from a career in government service to become the company’s top strategic planner. He groomed her from the beginning to be one of the company’s top executives.
Here are some excerpts from the fourth quarter 2012 conference call:
Phebe N. Novakovic - Chairman, Chief Executive Officer, President and Chief Operating Officer
“Yes, so, look, let's take that in several parts. What you're going to see us do is pursue -- and I can't say this enough -- pursue margin expansion and generate cash and earnings. We are not going to chase revenue. We're going to stick to our knitting and do what we know how to do. This company has a long history of operating excellence, and it's perform, perform, perform.”
“Yes, that's a very good question. It ought to be clear from the charges that in some respect we took our eye off the ball. Some of our business units performed superbly, but that benefit hasn't accrued to the benefit or that value hasn't accrued to the benefit of our shareholder, and you can better believe that we are going to be focused like a laser beam on that. I can tell you that I have -- I'm very close to our business unit presidents. I know their business. They know their business, and we are completely aligned with the prime directive. And that prime directive is drive cost out of our business, generate earnings and cash, expand our margins and reassure our shareholders that we're wise stewards of their capital. We are going to be focused on operations, and you're going to see that across every single one of our businesses. And let me tell you something else, too, as I think about our business.”
The verdict on the performance of Novakovic will be out in next three to five years time, but I am optimistic about the prospects of General Dynamics under her management.
VI) Value and Price
General Dynamics is currently trading in the $66 to $72 range. Looking at continued year-over-year growth rate of 12% in the Gulfstream Aerospace division and continued year-over-year contraction of revenue of 2.5% in Marine Systems, 4% in Combat Systems and 6% in Information Systems and Technology division and assuming modest improvement in margin I project the valuation three years out as below. I expect the EPS to improve to $9.52 by 2015. There is also the possibility of P/E expansion and reversion to the mean when the market pessimism of the defense sector abates. Assumed cash flow generation of $3 billion per year on average over the next three years also provides opportunity for management to increase per-share intrinsic value via share buybacks. I believe for a high-quality business like General Dynamics with strong competitive advantages, a P/E of 15 is normal. Projected annual total return (dividends plus capital appreciation) ranges from 24% to 37% in my estimation. One of the key drivers of valuation should be the positive growth in the Gulfstream unit of the Aerospace division. There is scope for growth in select areas of IS & T division including cyber security.
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The market is focused on the short term which allows us to own this wonderful business which will be successful and growing decades from now. Although there may not be any immediate catalysts in next few months, I can think of the following catalysts over the next three years.
(1) Fear of the impact of sequestration and budget cuts are proved to be overstated and reversion to mean causes P/E expansion from 10 to 15.
(2) China is becoming a major competitor to the U.S. and an increased role by U.S. in the Asia Pacific theater may bring some stability to the defense spending.
(3) Increase in growth in international sales, especially to U.S. allies in the unstable Korean Peninsula, may be a positive factor.
(4) Continued growth in the Gulfstream unit of Aerospace division (G650 has potential to grow) may be better recognized by the market as a valuation driver. There is also the option for the management to spin off the Gulfstream unit as a separate company if desired.
(5) Opportune share buybacks and annual dividend increases and prudent deployment of cash flow ($3 billion per year) over the next three years will increase the intrinsic value of the company. company has reduced share count by 10% in the last five years when it was more focused on acquisitions. Dividends have grown from $0.88 per year in 2006 to $2.24 per year in 2013.
VIII) Specific Risk
As in any investment there are some risks associated with an investment in General Dynamics. Following are some of the risks:
1) The business jet market is cyclical and if there is a severe recession, new orders will be affected and some of the existing orders may be scaled back or cancelled.
2) Many of General Dynamics' business are capital intensive and have fixed costs. If revenue declines more than expected then margins and profitability will be impacted.
3) U.S. government accounts for 70% of overall sales. Budget pressures and politicization of defense procurement can be a negative factor.
4) Complex defense projects and design of new business jets entails execution risks.
5) Information Systems division represents 30% of total sales currently, and this may contract more than expected if the U.S. government decides to cut spending drastically.
IX) Why Is This Cheap?
Albert Einstein once said, “In the middle of difficulty lies opportunity.” I believe this is definitely the case with General Dynamics.
(1) Market is overly pessimistic and as always focused on the near-term factors while ignoring the high quality nature of the underlying business.
(2) Market is under-appreciating the Gulfstream unit of Aerospace and the growth potential there.
(3) Market is taking a wait-and-watch approach due to uncertainty of 2013 budget negotiations.
(4) Market is waiting to see how the leadership changes with Novakovic and her management reshuffle will play out and whether company can achieve the cost cuts and margin expansion.
Comments and questions welcome.
Disclosure: I own shares of General Dynamics. I have also sold January 2015 puts on General Dynamics at $55, $60 and $65.
1) GD 2012 Annual Report
2) Warren Buffets mention of General Dynamics 1992 Letter
3) The Outsiders Book
I have used information from GD investor relations website, investor presentation and financial statements. I have referenced information from Morningstar.
About the author:Mritik Capital Inc. is a financial advisory firm with focus on identifying quality businesses with durable competitive advantages that are undervalued. Our first goal is to preserve the capital of our clients and look for strategies for enhancing their net worth based on opportunities that present compelling risk adjusted reward.
Please note that investing offers both risks and rewards. Before investing do your own due diligence and consult your financial advisor.