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Nathan Parsh
Nathan Parsh
Articles (145) 

Why Buying More General Dynamics Made Sense

The company has underperformed the S&P 500 this year, but this has given the stock a very low valuation and a high yield

July 11, 2020 | About:

The iShares U.S. Aerospace & Defense exchange-traded fund (ITA) has suffered a 29% decline since the beginning of 2020. General Dynamics (NYSE:GD) has managed better, losing 20% of its value over this period of time. This still compares unfavorably to a 1.5% loss for the S&P 500.

Much of the loss in the share price for General Dynamics can be attributed to the market-wide selloff following the increase in Covid-19 cases in the United States. While much of the market has recovered the majority of is losses, General Dynamics has not been able to do so. This likely stems from the most recent earnings release, which missed estimates. Still, there is a lot to like about this aerospace and defense company that I decided to add to my position earlier this week.

Recent earnings results – headwinds in aerospace

General Dynamics reported first-quarter earnings results on April 29.

Source: General Dynamics First-Quarter Earnings Presentation, slide 4.

Revenue for the company declined nearly 6% while earnings per share decreased more than 5%. Revenue was $500 million below Wall Street’s expectations and earnings per share were 13 cents lower than estimated. Year-over-year revenues haven’t declined since the third quarter of 2017. Even with all of this, General Dynamics’ operating margins declined just 10 basis points to 10.8%, a solid performance given the circumstances.

Much of the decline in revenue came from the aerospace segment, which decreased 24.5% to $1.7 billion. This was mostly due to the company’s Gulfstream business. General Dynamics delivered 11 fewer Gulfstream aircraft compared to the first quarter of 2019. Deliveries were delayed as coronavirus-related restrictions reduced travel. Revenue for this business was lowered by $550 million. Excluding this from the total, revenue would have been flat against the prior year.

If travel restrictions remain in place for long or have to be reinstituted where they’ve been lifted, then Gulfstream could see a further slowdown in work. Aerospace has been a real source of strength for the company (23% growth in first-quarter 2019 and 17.4% for full-year 2019), so fewer deliveries would have a material impact on business results.

While Covid-19-related restrictions may be here longer than investors hope, General Dynamics’ Gulfstream aircraft remain in high demand under more normal circumstances. For example, Gulfstream deliveries increased 31% in the first quarter of last year and 21% for all of 2019. Excluding the impact of Covid-19 on the Gulf Stream program, this business would have seen revenue grow by 1.1%. This shows that the business can perform well when a pandemic isn’t occurring. I expect demand to be weak for the company for at least a few quarters as the coronavirus apparently will be with us for some time. Operating margins for the aerospace segment were down 40 basis points to 14.2% due to fewer Gulfstream deliveries.

On the other hand, defense revenues as a whole improved 0.5% to $7.2 billion.

Growth for these businesses was led by Marine Systems. Sales for this segment were higher by 9.1% to $2.2 billion. Marine Systems benefited from increased volumes for the Virginia-class Block V and Columbia-class submarine programs. Operating margins were down 50 basis points to 8.2% year over year, but up 40 basis points sequentially. Funded backlog for this segment increased 30% from fourth-quarter 2019 to $6.1 billion.

Revenue for the Combat Systems segment increased 4.4% to $1.7 billion. While Covid-19 did cause some disruptions, demand for Abrams and Stryker vehicles was strong as was the munitions program. Operating margins were 13.1% for the quarter, an improvement of 50 basis points from the previous year. Orders grew 25% for the quarter.

Information Technology sales dropped 8.3% to $2 billion. This segment had a difficult comparison to the previous quarter due to divestitures made last year. These divestitures will be lapped in the third quarter. Where Information Technology really shines in its ability to drum up new business. Backlog orders increased almost 14% to $9.5 billion. The book-to-bill ratio was 1.2 for the quarter, above the company’s overall book-to-bill ratio. Operating margins expanded 30 basis points to 7.5%.

Missions Systems declined 3.6% to $1.1 billion. Naval, Air and Electronic Systems saw increased demand and volumes were stable for Space, Intelligence and Cyber Systems, but disruptions for short-cycle products were too much to overcome. Operating margins increased 50 basis points to 13.3% even as this segment produced flat earnings growth.

General Dynamics updated its guidance for the rest of the year as well.

Source: General Dynamics First-Quarter Earnings Presentation, slide 12.

The company now expects an earnings per share midpoint of $11.35 compared to $12.58 previously. Really the only change in the guidance stems from the expectation of 20 to 25 fewer Gulfstream deliveries, which was enough to knock of approximately $1.5 billion in revenue. The rest of the guidance remains unchanged.

Growth prospects & total teturn possibilities

As I’ve touched on previously, the defense sector has a lot of tailwinds for growth. Chief among them is that defense spending continues to rise both in the U.S. and abroad. This has benefited most of the names in this sector and General Dynamics is no different.

Source: General Dynamics First-Quarter Earnings Press Release.

The company’s backlog ballooned 24% to $85.7 billion, which is more than two full years of revenue based on 2019 results. One area of caution is that the book-to-bill ratio declined to 1.1 in the first quarter, but is likely due to Covid-19. Nearly three-quarters of this backlog is funded.

More than half of the backlog is in the Marine Systems, but much of comes from nuclear submarine orders. These are long-term contracts that should reach completion due to the number of years it takes to finish production on a block of submarines.

While governments around the world will likely be strapped for capital following the economic impact of Covid-19, defense spending isn’t likely to take a major hit. Again, many of these types of contracts cover multiple years and this sector’s largest customer, the U.S. government, rarely lowers its spending on defense.

For me, this long-term thesis outweighs any short-term headwinds that General Dynamics may have, which led me to purchase another batch of shares on July 8 at $143.54.

Using the company’s guidance for the remainder of the year, the stock traded with a price-earnings ratio of 12.6 at my purchase price. Value Line says that the stock has an average valuation of 14 times earnings since 2010. Using data from just the past five years, the average price-earnings ratio increases to 16.7. For context, if this were to be the average valuation for the entire year, then it would be the lowest average for General Dynamics since 2013.

I have target price-earnings ratio of 14 to 16 for General Dynamics. This incorporates the five- and 10-year average price-earnings ratios without becoming overly bullish, giving the stock a target price of $159 to $182 based off of company guidance.

The stock could increase 11% to 27% from my purchase price just by trading within its five- and 10-year price-earnings ratio range.

And this is before adding in the stock’s dividend. General Dynamics now has 29 consecutive years of dividend growth after raising its dividend by 7.8% for the May 8 payment. Shares yielded 3.1% at the time of purchase.

The stock has averaged a yield of 2% and 2.3% over the past five and 10 years respectively. The current yield more than a full percentage point higher than its long-term average helps reinforce the belief that General Dynamics is undervalued today.

Using our price target range, General Dynamics’ annualized dividend of $4.40 would yield between 2.4% and 2.8%. Between share price growth and dividends, the company could see a total return ranging from 14% to 29% from where I added to my position.

Final thoughts

General Dynamics still has not recovered from the selloff caused by the Covid-19 pandemic. This has caused shares to trade well below the historical valuation and with a much higher than usual dividend yield.

The Gulfstream business was challenged as fewer deliveries were made during the most recent quarter. This likely will be a slight hinderance in the short term, but I try to buy stocks for the long term. Stocks rarely trade below their historical valuations when the business has few weaknesses. Finding higher total returns means buying when there are issues with a business.

Even though my investment time frame is quite long, I like adding to our positions when I feel they can deliver a solid total return. The expected total return for the stock made buying more shares of General Dynamics an easy decision to make.

Disclosure: The author has a long position in General Dynamics.

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About the author:

Nathan Parsh
I am originally from Detroit, Michigan, before moving to Maryland to begin a career as an educator. This is my 14th year teaching. My wife and I have two young children who keep us on our toes.

Rating: 4.7/5 (3 votes)



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