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Often the opportunity to acquire a great business at an attractive price occurs when the company or industry is facing serious headwinds that are obvious to most market participants. Due to the inability of Congress to pass a fiscal year 2013 budget, as mandated by the Budget Control Act of 2011 (BCA), a $487 billion, or approximately an 8%, reduction to previously-planned defense funding over the next decade has taken effect. In addition in the BCA, there is a sequester mechanism, which would impose an additional $500 billion, or 9% reduction of planned defense spending over 9 years starting in 2013. These issues are well-known and the large defense companies including General Dynamics (NYSE:GD) have already begun to right-size their cost structures, and to look for expansion in adjacent industries that can leverage the design, execution and international competitive advantages that have led to decades of growth in the past. I believe General Dynamics offers a very attractive long-term investment opportunity, with a very strong and honest management team that is focused on maximizing shareholder value.

General Dynamics had an extremely difficult 2012, where the company saw operating earnings, operating margins, free cash flow and return on invested capital decline. Europe's depression-like economic environment was a large contributor, as were execution issues in shorter-cycle defense businesses, and management stated that several recent acquisitions haven't performed up to par. General Dynamics is a company that acknowledges when it underperforms in a forthright and honest manner, and then takes aggressive step to correct the issues. The company is reducing its cost structure substantially in an effort to put expenses in-line with the new economic realities that are facing the defense business, in this time of sequestration and reduced defense spending. Management is focused on keeping overhead, plant equipment and working to an absolute minimum level, while the company's primary goal is to create value through maximizing returns on invested capital. Intelligent capital allocation is a huge part of this story and on March 6th, 2013 the Board of Directors increased the quarterly dividend by 9.8%, to $0.56 per share.

As of December 31st, 2012 General Dynamics had 351MM diluted shares outstanding, so at a recent price of $67.69, the company has a market capitalization of $23.76 billion. Despite being an extremely acquisitive company, General Dynamics has been able to reduce shares outstanding from 408MM in 2007, to the current diluted share count, which is a roughly 14% reduction. In 2003, General Dynamics earned $2.52 per diluted share, which grew to $6.87 per share in 2011. 2012 resulted in a loss of $.94 per share, largely due to a nearly $2.3 billion asset impairment. The company ended the year with $3.296 billion in cash and cash equivalents, and long-term debt of $3.908 billion, which puts the enterprise value at roughly $24.372 billion. General Dynamics also has close to a $4.9 billion pension deficit, largely due to the low interest rate environment, which would increase the enterprise value to $29.272 billion if one wishes to include it. Even though the company posted a GAAP loss in 2012, free cash flow generation was quite strong at $2.235 billion, giving the company about a 9.4% free cash flow yield.

General Dynamics has been able to consistently achieve returns on invested capital in the low to mid-teens over the last decade, while return on equity has hovered around 20%. The return on assets has generally been around 7.5%-8%, so the company is clearly benefitting from the high value-added nature of its products and services. While defense spending is incredibly competitive, the U.S. government is likely to continue rewarding the companies that have successfully managed huge multi-billion dollar programs for decades, such as a General Dynamics. While the exit from Iraq and the planned exit from Afghanistan sound wonderful, unfortunately it is not hard to imagine scenarios that could potentially require military action. Needless to say, the continued rhetoric from North Korea is increasingly alarming, and historically period of widespread economic turmoil has resulted in active military action. This isn't good for anybody, but defense contractors serve an essential need, particularly in the areas of preventing and dissuading other hostile countries from using nuclear weapons.

In 2012, 66% of the company's revenues were from the U.S. government, 13% were from U.S. commercial customers, 8% were from international defense customers and the remaining 13% were from international commercial customers. The largest customers are the U.S. Department of Defense (DOD) and the intelligence community. General Dynamics is expanding into growth platforms such as healthcare and LNG transportation, which are less reliant on the traditional defense budget that is obviously under serious pressure.

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Source 2012- Annual Report for General Dynamics

General Dynamics operates through four business groups: Aerospace, Combat Systems, Marine Systems and Information Systems and Technology. These groups generated 22%, 25%, 21% and 32% of revenues in 2012, respectively.

Gulfstream's revenue grew over $800MM and earnings improved by $110MM in 2012, bolstered by the release of two new aircraft, the G280 and G650. The G650 has the longest range, fastest speed, largest cabin and most advanced cockpit in the Gulfstream fleet and should be a tremendous addition to the business-jet space. The G280 has replaced the G200, and it will offer a larger cabin and the longest range at the fastest speed in its class. International orders comprise approximately 60% of the group's backlog, and General Dynamics is seeing increasing demand from emerging markets. Private companies and individuals collectively represent approximately 60% of the group's backlog, and GD also garners a great deal of business from governments and militaries around the world. Gulfstream's aircraft are designed to minimize lifecycle costs while maximizing commonality of parts among the various models.

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The Combat Systems unit is an extremely strong competitor in the design, development, production, support and enhancement of tracked and wheeled military vehicles, weapons systems and munitions for the United States and its allies. Some examples of the unit's product line are the Stryker wheeled combat vehicle and the Abrams main battle tank. These are core military vehicles and offer continuing opportunities for upgrades and modernization to meet evolving requirements. An example of General Dynamic's continuing innovation to keep up with the times is the development of the double-V-hulled Stryker, which is designed to further enhance soldier protection from improvise explosive devices (IEDS). In the past two years, roughly 750 double-V-hulled vehicles have been delivered to the U.S. Army, and in 2102, the group secured contracts to convert previously delivered Stryker vehicles to the double-V-hull configuration. For the Abrams line, the group created the SEP-configured tanks, which is a digital platform with an enhanced command-and-control system, second-generation thermal sights and improved armor. For ground forces, the Combat Systems group manufactures vehicle armor, M2 heavy machine guns and MK19 and MK47 grenade launchers. For airborne platforms, the group produces the high-speed Gatling guns for fixed-wing aircraft and the Hydra-70 family of rockets, among other products.

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The Marine Systems group designs, builds and supports submarines and surface ships, and General Dynamics is one of two primary shipbuilders for the U.S. Navy. Currently, the group is constructing the Virginia-class nuclear-powered submarine, the Arleigh Burke-class (DDG-51) and Zumwalt-class (DDG-1000) guided-missile destroyers, and the Mobile Landing Platform (ML) auxiliary support ship. The group is constantly innovating and improving the effectiveness and efficiency of its designs. In the 4th quarter of 2012, the group was awarded a contract for the construction of two liquefied natural gas (LNG)-powered containerships. These are the types of programs, which should help the company offset the loss of revenue from reduced defense spending by the U.S. government.

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The Information Systems and Technology group provides technologies, products and services that support a wide range of government and commercial communication and information sharing and security needs. The three-part portfolio is centered on secure mobile communication systems, information technology solutions and mission support services, and intelligence, surveillance and reconnaissance systems. In a world engulfed in cyber warfare, this group is vital to governments, which need to stay in front of the curve to defend its information and systems. The group supplies network-modernization and IT infrastructure services to U.S. government customers, commercial wireless network providers and federal, state and local public safety agencies. Another growth platform that is not dependent on defense spending is the fast growing market for government and commercial healthcare technology modernization. This includes data management, analytics, fraud prevention and detection software etc. Because of the essential nature of Information Systems and IT, this has become an increasingly competitive environment, which has pressured both sales and margins.

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The days of explosive revenue growth for GD are likely to be over in the short-term, but an improved focus on profitability and expansion in healthcare and energy transportation could lead to stable margins. Capital allocation has historically been really strong and I'd look for the company to be an aggressive buyer of its stock if for any reason it were to sell off materially. According to Morningstar, the Mean analyst estimates for 2013 and 2014 EPS are $7.09 and $7.47, respectively. That allows the investor to buy a business with a consistent 20% return on equity for less than 10 times forward earnings. After the recent dividend increase, the stock yields close to 3% so the investor will get paid for waiting till the defense environment improves. I believe General Dynamics can trade at $80-$85, as the company wins large contracts on its various leading programs, and as the market rewards the company with a slightly higher multiple based on less uncertainty pertaining to the spending environment. One strategy that might make sense is to sell the January 2015 $70 puts for about $12 per contract. This would create a nearly 21% return on the maximum risk of $5,800, or about 11.73% annualized. Your biggest risk is that if the stock trades below $70 at expiration, you'd be exercised and would end up owning 100 shares of GD at $58.00 per share. This provides a greater margin of safety than buying the stock outright and offers similar upside potential.

Source: An Investment Strategy For General Dynamics When Fiscal-Austerity Threatens Growth