With the S&P 500 trading with an average price-earnings ratio of more than 24, it can be difficult to find stocks trading at an attractive valuation. At the same time, the 1.8% average yield on the index doesn’t offer much in the way of income.
There are some stocks that offer solid growth prospects, a higher yield and a long history of dividend growth all while trading with a reasonable valuation. One company that I feel checks all of these boxes is General Dynamics Corp. (GD, Financial). I feel so strongly about the future of this company (and its ability to grow dividends) that I opened a position in General Dynamics on Dec. 26. Here’s why.
Recent earnings results and growth prospects
General Dynamics reported third-quarter earnings results on Oct. 23.
General Dynamics’ had earnings of $3.14 per share for the quarter, 8 cents higher than estimates and an 8.7% improvement from last year’s results. Revenue grew 7.3% to $9.8 billion, slightly ahead of analysts’ expectations.
Aerospace revenues grew nearly 23%, primarily due to an increase in the number of aircraft delivered. The company made its first G600 Gulfstream delivery during the quarter. General Dynamics launched its G700 jet line as well and expects first delivery in 2022.
Revenue for Combat Systems was higher by 14.2% on increased demand for products such as the Abrams tank and Stryker vehicle. Marine Systems grew 11.6% as the Virginia-class Columbia Ballistic-Missile Submarine program continues to see high volumes. Information Technology sales were 10% lower due in large part to divestitures made in previous quarters and program timing. Mission Systems was essentially flat, though margins were higher year over year. Overall, operating margins of 12.5% matched the previous year as gains in Mission Systems and Marine Systems were offset by declines in Aerospace and Combat Systems.
General Dynamics expects earnings of $11.91 per share in 2019, which would be a 6% increase from the previous year.
The aerospace and defense sector continues to be one of my favorite areas due to increased government spending. Except for Social Security, the U.S. spends more on defense than any other item in the budget. Defense spending will reach $738 billion for fiscal 2020, which is an increase of nearly 8% from fiscal 2019.
General Dynamics also recieved a variety of contract awards during the quarter. A sampling of awards is listed below:
- $22.2 billion contract from the U.S. Navy for nine Virginia-class submarines.
- $731.8 million contract for Next-Gen Satellite Communications Systems.
- $1.3 billion from Canada for armored combat support vehicles.
- $2 billion contract with Spain to provide wheeled vehicles.
- A portion of a $2.5 billion contract from the U.S. Navy to replace and modernize intelligence systems at facilities worldwide.
The company finished the third quarter with a backlog of more than $67 billion. The funded backlog at this point consists of more than two full years of revenue. This backlog is likely to grow as defense spending continues to increase.
General Dynamics also offers a diversified lineup of products, from information technology services to armored vehicles to nuclear powered submarines to business jets. This helps the company insulate itself if one segment of the business experiences a decline in sales. This occurred in the last quarter, where two divisions had declining sales yet the overall company grew at a high single-digit rate.
And the businesses are very entrenched. For example, General Dynamics is one of just two companies that produces submarines. As shown above, it just received a massive deal to produce a new block of submarines. The company's ground and marine programs also play a crucial role in the U.S. military. These deals also have long life cycles, making it highly unlikely that customers will change contractor mid-cycle.
Another factor working in General Dynamics favor is that politicians on both sides of the aisle are very reluctant to cut defense spending as closure of bases, reduction in the civilian workforce, lower combat pay and military health benefits would be hard to explain to constituents come election time. Congress is so serious about defense spending that it passed a bill in 2013, with massive support from both political parties, that blocked military bases from being closed in the future.
Lastly, the potential for global conflicts, as horrible as they may be for the people involved, will only lead to higher sales for defense contractors. No one can predict for certain when such a conflict will arise or if it will escalate into war. For example, a few weeks ago, no one would have thought that the U.S. and Iran would conduct missile strikes against targets in Iraq. Where this situation will go is unknown.
Taking all of this into account, General Dynamics clearly has the recent business results and future growth prospects that I am looking for in an investment.
This Dividend Aristocrat offers consistent dividend growth
After increasing its dividend 9.7% for the May 10, 2019 payment, General Dynamics has now raised its dividend for 28 consecutive years. This gives the company the longest dividend growth streak among all stocks in the aerospace and defense sector, as well as qualifies the stock as a Dividend Aristocrat. General Dynamics is just one of 57 companies in the S&P 500 that has at least 25 consecutive years of dividend growth.
What has always impressed me about General Dynamics is the consistency of its dividend increases. The company has raised its dividend by an average of:
- 10.5% per year for the past three years.
- 10.6% per year for the past five years.
- 10.5% per year for the past 10 years.
The annual increase has generally been about the same for multiple periods of time. Business results can fluctuate from year to year and so too can the dividend increase. Many companies base their dividend increases on how the business is performing at the moment.
The annual increase can vary over the years even among companies with multiple decades of dividend growth. The fact General Dynamics’ average increases haven’t varied almost at all should illustrate just how consistent the business has performed over the years.
Shares of the company yield 2.3% at the time of purchase, above the average yield of 1.8% for the S&P 500.
The most recent increase is slightly below the company’s historical average, but I believe that future growth is likely to occur when looking at its track record and the low payout ratios.
General Dynamics paid out $3.99 in dividends per share in 2019. Based off of the company’s earnings per share guidance for the year, the EPS payout ratio is just 34%. This compares rather favorably to the five- and 10-year average payout ratios of 33% and 30%.
Free cash flow also shows that the company’s dividend is not in danger of being cut.
General Dynamics paid out $295 million in dividends in the most recent quarter, while producing $847 million in free cash flow for a payout ratio of 35%.
Over the last four quarters, the company has distributed $1.1 billion in dividends and produced $1.8 billion in free cash flow for a payout ratio of 61%. This payout ratio is nearly double the five- and 10-year averages, but this appears to be an outlier.
Looking out over a time horizon, General Dynamics paid $3.8 billion to shareholders from 2015 through 2018 and produced $9.6 billion in free cash flow during this time. The average payout ratio over this period was 40%.
The payout ratios look very healthy. Even a prolonged recession likely wouldn’t impact the company’s ability to grow its dividend. General Dynamics’ dividend has increased through the past two recessions and the company actually improved its profitability before, during and after both of the last two recessions.
General Dynamics’ nearly three decades of dividend growth, low payout ratios and ability to grow distributions during multiple recessions made it a fairly easy choice to add to the portfolio.
The valuation is very reasonable in an unreasonable market
The S&P 500 currently has a price-earnings ratio of 24.3. General Dynamics, on the other hand, has a much cheaper valuation. Using our purchase price of $178 and expected earnings for the year of $11.99, the stock trades with a price-earnings ratio of 14.9. For context, the stock has a 10-year average multiple of 13.4.
Because of the company’s prospects for growth, dividend history and recession performance, the stock deserves a premium multiple to its historical average. I find that a target price-earnings ratio of 16 seems reasonable given the company’s business performance and growth prospects. Even at this premium to its own historical average, shares of the company trade at a steep discount to the valuation of the S&P 500.
Using my target multiple and the company’s expected earnings per share for the year, I have a fair value of $191 for General Dynamics’ stock. This gives us more than 7% upside from our purchase price. Add in a 2.3% yield and this is a decent potential return for a company with strong growth prospects and decades of dividend growth.
Risks to my thesis on General Dynamics
With any investment, there are always risks that could impact the company and stock’s performance. This is also true for General Dynamics.
General Dynamics receives approximately 65% of annual revenues from the U.S. government. Companies that rely on a single source for nearly two-thirds of its business is always at risk that the customer could find a different supplier or that purchases could dry up.
The U.S. government, however, isn’t just an ordinary customer when it comes to defense spending.
Source: U.S. Defense Spending.
The U.S. spent more on defense last year than the next seven largest spenders combined. Breaking it down even further, more was spent on defense by the U.S. than the other 144 countries of the world put together. As stated above, defense spending is only set to increase. Given these factors, I find it highly unlikely that the U.S. government will decrease spending in the near future.
General Dynamics, thanks to its commercial aerospace business, is also less exposed to possible defense spending reductions in the future. For comparison purposes, U.S. spending accounts for 82% of Northrop Grumman’s (NOC, Financial) revenue, 70% of Lockheed Martin’s (LMT, Financial) revenue and 68% of Raytheon‘s (RTN, Financial) revenue. General Dynamics is in a much better position to withstand any possible decrease in government spending as it is not nearly reliant on the Department of Defense for revenue as its peers.
Another possible risk that some investors may find with the defense sector as a whole is the upcoming presidential election. Love him or hate him, the current occupant of the White House has overseen a significant increase in defense spending. Some might feel a Trump defeat may lead to drastic declines in defense spending.
Going with that line of thinking, some might believe that General Dynamics, along with the rest of the defense sector, may contribute all they can to make sure Trump is re-elected. That theory flies in the face of the facts though.
Source: Open Secrets.
While contributions to Republicans was higher during the election cycles from 2012 to 2018, General Dynamics also contributes to Democrats. The company contributed more to Democrats in 2008 and 2010, and the same is true so far for 2020.
In 2016, General Dynamics gave more than $43,000 to Hillary Clinton, a total greater than any other candidate for any political office that year. In fact, Democrats held the top seven spots for contributions from the company in 2016. Trump received just under $17,000 from the company, good for 11th place.
Looking at these factors, a change in who resides in the White House may not make all that much of a difference when it comes to defense spending.
Final thoughts
General Dynamics hits all the marks for what I am looking for in an investment right now. The company’s recent results were solid and the backlog is plentiful. Defense spending continues to reach new highs.
The company also has a strong track record of dividend growth and has a growth streak that surpasses all of its peers. Shares also have a price-earnings ratio that I feel undervalues the company’s business prospects. Even a change in president isn’t likely to impact defense spending all that much. And if it did, General Dynamics is better situated than its main competitors due to a lower reliance on government spending for revenue. For all of these reasons, buying General Dynamics was an easy investment choice.
Disclosure: I am long General Dynamics and Lockheed Martin.
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