(Published Feb. 10 by Bob Ciura)
Defense stocks have been among the stock market’s biggest winners for a long time. For example, defense giant General Dynamics (GD, Financial) has seen its share price soar 159% in the past five years.
Not only that, but General Dynamics has unloaded billions to investors in share repurchases and dividends.
In fact, General Dynamics is now a Dividend Aristocrat. The Dividend Aristocrats are companies in the Standard & Poor's 500 Index that have raised their dividends for 25-plus consecutive years.
You can see the entire list of 51 Dividend Aristocrats here.
General Dynamics is one of the most recent additions to the Dividend Aristocrats list.
Its capital allocation announcements have been extremely generous in the past few years. Last year in March, the company raised its dividend by 10%, along with a 10 million-share repurchase authorization.
Since the company’s fundamentals have continued to improve over the past year, it’s likely General Dynamics will fire off an equally impressive dividend increase and share repurchase authorization this time around.
Financial performance review
General Dynamics is a global aerospace and defense company. Its products and services portfolio consists of business aviation, combat vehicles, weapons systems and munitions.
The company operates four reporting segments: Aerospace, Combat Systems, Information Systems & Technology and Marine Systems. Each business is roughly of equal size.
The Aerospace business primarily manufactures business jets under the Gulfstream brand. This segment has enjoyed strong growth over the past few years.
Source: 2015 Annual Report, page 8
The Combat Systems business manufactures combat vehicles and related weapons systems and munitions.
Furthermore, General Dynamics’ Information Systems and Technology business sells technologies to the military and for civilian, state and commercial purposes.
Finally, the Marine Systems group builds nuclear-powered submarines and surface combatants for the U.S. Navy and also Jones Act vessels.
The company generated $31.4 billion of sales in 2016. Total revenue dipped 0.4% from the previous year.
Source: Fourth Quarter Earnings Report
One factor negatively impacting General Dynamics is the strong dollar. The dollar has risen significantly against most international currencies over the past two years, which has weighed on General Dynamics’ international business.
Fortunately, General Dynamics made up for this with margin expansion. Cost cuts allowed the company to generate an operating margin of 13.7% in 2016, up 40 basis points from 2015.
Among its operating segments, Information Systems and Technology and Marine Systems performed the best, with 2.5% and 2.4% revenue growth for 2016.
This helped offset a 5.5% decline in the Aerospace business, which was driven by falling Gulfstream jet orders.
The Aerospace segment enjoyed a prolonged period of steady growth from 2013 to 2015 so a slight decline in 2016 is not a major concern.
Overall, General Dynamics’ earnings per share rose 8.7% in 2016 to $9.87. Thanks to cost cuts, along with rising global defense spending, the company has a positive growth outlook.
Growth prospects
The most important growth catalyst for General Dynamics is defense spending, both in the U.S. and the international markets.
General Dynamics’ biggest customer is the U.S. Department of Defense, which accounts for more than half the company’s annual sales.
From 2013 to 2015, General Dynamics’ sales to the Department of Defense fell nearly 5%. This presents a challenge for future growth, but there is reason for optimism given the likely policies of the incoming administration.
President Donald Trump has advocated higher levels of defense spending in the U.S., which would be a tailwind for General Dynamics.
In addition, General Dynamics has enjoyed rising sales to other government agencies including the Department of Homeland Security and various intelligence agencies over the past few years.
International markets are likely to continue raising defense spending. Geopolitical risk remains elevated across many parts of the world.
There should be a long runway of growth for the company up ahead as General Dynamics’ total project backlog at the end of 2016 was $59.8 billion.
Separately, General Dynamics’ free cash flow should grow moving forward, thanks to a laserlike focus on capital discipline. The company cut capital expenditures by 31% in 2016.
General Dynamics generated return on invested capital of 18.1% in 2016, up from 17.4% in 2015.
Source: Fourth Quarter Earnings Report
This indicates the company is adept at efficiently deploying capital, which will help support its dividend growth in 2017 and beyond.
Dividend analysis
General Dynamics has displayed excellent growth in earnings per share and dividends over the past several years.
Source: 2015 Annual Report, page 22
There is plenty of room for continued dividend growth in 2017 because the current dividend represents a fairly small percentage of earnings per share and free cash flow.
Even though General Dynamics reported flat revenue in 2016, the company still generated $1.8 billion of free cash flow for the year.
The company distributed $911 million of dividends last year, which amounts to a roughly 50% payout ratio in terms of free cash flow.
General Dynamics’ dividend increase prospects are improved by the company’s strong balance sheet.
At the end of 2016, the company held $2.3 billion in cash, and just under $3 billion of long-term debt, and it has a 26% debt-capital ratio.
As a result, General Dynamics does not need to withhold a large amount of annual cash flow for the purpose of paying down debt, which leaves more cash flow available for dividends.
General Dynamics’ current annualized dividend is $3.04 per share. This accounts for just 31% of its 2016 earnings per share.
Final thoughts
Geopolitical risk is an unfortunate reality of the modern world. As a result, the major U.S. defense companies like General Dynamics are seeing robust growth in earnings per share and cash flow.
Last year, General Dynamics raised its dividend on March 2, meaning another raise is right around the corner.
This time, investors should fully expect another double-digit dividend increase in 2017.
The company could easily raise its dividend by 15% to 20%, but General Dynamics usually takes a more balanced approach between dividends and share repurchases.
Similar to last year, General Dynamics will likely announce a major addition to its share repurchase program, on top of a 10%-plus dividend hike for 2017.
Disclosure: I am not long the stock mentioned in this article.
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