General Dynamics (GD) is the kind of company that I like to invest in, and here are the reasons why.
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- Free Cash Flow Generation: First and foremost, General Dynamics has been historically a strong generator of free cash flow (FCF) with attractive returns on invested capital (ROIC). The company has generated between $2.2 billion and $2.6 billion in free cash flow over the last five years for a total of $12.73 billion. With the exception of 2012, return on invested a capital has averaged ~17.4% over the last five years.
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- Competition: Although GD faces competition among its various business segments, the various business segments operate in a duopoly or oligopoly environment; moreover, the company's products and services are unique and difficult to copy, which limits competition. For example, the marine division competes with Huntington Ingalls as one of two premier boat builders for the US Navy. This division is considered to have some of the best engineers in the world and consult on projects outside of just GD. This division builds and services the U.S. nuclear submarine fleet. While the U.S. Navy may shift spending from one period to the next, it is still likely to spend the money to service and maintain its submarines, so concerns of austerity become more a timing issue.
- Gultstream, the aerospace division, is also unique, and while it has competition from companies like Bombardier, there is not a perfect overlap of products; these aircraft are some of the most highly coveted status symbols in the world. They are a highly engineered specialized product. I am stating the obvious that they have a wide and deep "moat" and therefore margins and profitability are likely going to be sustainable. The largest risk is likely cyclicality of demand due to a recession.
- What I also find attractive is that the product cycles for these businesses are very long. This is not like a technology company where another company comes along with a better product and suddenly your product is obsolete.
- Balance Sheet: The balance sheet is strong. The company has $3.2 billion in cash and equivalents and long-term debt of $3.9 billion. Working capital is ~$4.1 billion. Debt to equity was 34% at the end of FY 2012.
- Share Buyback: Management is shareholder oriented and has had a history of buying back stock. The company has repurchased 18.9 million shares on the open market in 2010, 20 million shares in 2011 and 9.1 million shares in 2012. This resulted in reducing the shares outstanding by 8%. On December 31, 2012, approximately 10.9 million shares remained authorized by the board for repurchase, approximately 3 percent of the shares outstanding.
- Dividends: Management has a terrific history of paying dividends. It has raised the dividend 16 years in a row. On March 16, 2013, it raised the dividend 9.8% to $0.56 from $0.51.
- Valuation: Here is what caught my interest and that is the current valuation. General Dynamics is a "great company selling at a very fair price" or 10.6x current forward earnings. The business appears undervalued given the nature of the products and services it provides; and its operating history. I think this stock should trade at 13 to 14 times normalized earnings or approximately 20% to 30% higher than where it trades now.
So, why is General Dynamics so cheap?
Like many of the big defense stocks (i.e. Northrop, Lockheed, Raytheon and others), investors have been cautious with the impact of sequester, the focus on austerity, and the wind down of the wars in the Middle East. It is not hard to understand that earnings growth may slow as government resources are reallocated and programs are cut. This is not just a "General Dynamics problem" but for the entire industry. To make matters worse, and specific to General Dynamics, the company lost money - $332 million for fiscal 2012 with $2 billion write-down of goodwill.
However, here lies the opportunity, because when pessimism rises and investors pull back, great companies often "go sale" and if your strategy is to "buy low and sell high," you must be willing to put capital to work when other investors seek liquidity.
Here is quick business overview. It has four divisions: aerospace, marine, combat, and information and technology group.
The Aerospace group, or Gulfstream, had particularly strong growth FY2012. Sales and earnings expanded by double digits as Gulfstream's revenue grew over $800 million and earnings increased $110 million. Gulfstream delivered two new aircraft models to the market in 2012, the G280 and G650. Management has expressed its confidence that these aircraft will be major contributors to the company's performance for several years.
Growth was not quite as robust at Marine Systems where earnings were up 8.5% from solid performance across all three of our shipyards. Management expects good performance from these businesses again in 2013. The Marine Systems group designs, builds and supports submarines and surface ships. General Dynamics is one of two primary shipbuilders for the U.S. Navy.
Alternatively within the Combat Systems group, Land Systems, the North America-based vehicle business, delivered improved sales, earnings and margins, a particularly good result given its exposure to reduced supplemental spending related to the wars in Iraq and Afghanistan. The Combat Systems group is a global leader 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.
Last, the Information Systems and Technology group is focused on providing critical technologies, products and services that support government and commercial communication and information sharing and security needs. The group consists of a three-part portfolio centered on secure mobile communication systems, information technology solutions and mission support services, and intelligence, surveillance and reconnaissance systems.
Operating Results in 2012: "What went wrong in 2012"
As mentioned earlier, FY 2012 was a tough year for GD. Revenues decreased in 2012 versus 2011. Revenues fell in the Information Systems and Technology's mobile communication systems business and in the Combat Systems group. However, the big hit came with the $2 billion write down of "goodwill" in the Information Systems and Technology group.
GD took a $2 billion goodwill impairment resulting from a decline in the estimated fair value of the group caused by topline pressure from slowed defense spending and the threat of sequestration, and margin compression due to mix shift impacting the projected cash flows of the group; it also took $110 of intangible asset impairments on several assets in the optical products business, most significantly the contract and program intangible asset, as a result of competitive losses and delays in the fourth quarter of 2012 indicative of lower overall demand caused by the economic downturn; in addition the company wrote down $58 million or substantially all of the remaining ruggedized hardware inventory, including $25 million in the third quarter, based on anticipated remaining demand for products that ceased production in 2012 along with other charges.
Dominant Defense Spending Themes
Despite sequestration and austerity, there are still several defense-spending themes that GD is likely to benefit from.
- The DoD has an increased emphasis on the Asia-Pacific region with problems in North Korea and friction between China and Japan.
- The U.S. military still has a number of troops deployed globally that need support and replacement parts.
- There is need to reset and replenish equipment and supplies damaged and consumed in Iraq and Afghanistan since 2001.
- There continues to be a need to modernize defense infrastructure to address the evolving requirements of modern-day warfare, including an emphasis on soldier survivability, enhanced battlefield communications and new technologies in the intelligence, surveillance and reconnaissance, unmanned systems and cyberspace arenas.
Investment and Business Risks
Despite what I think is a compelling value, GD is not without risk. The key customer is the U.S. Government. The U.S. government provides a significant portion of GD's revenues. In each of the past three years, approximately two-thirds of its revenues come from the U.S. government. U.S. defense spending has been driven by threats to national security. While the country has been under an elevated threat level for more than a decade, competing demands for federal funds, austerity, and or sequestration could cut, reduce or pressure spending.
A decrease in U.S. government defense spending or changes in spending allocation could result in one or more of the programs being reduced, delayed or terminated, which would likely negatively impact on financial performance.
Disclaimer: This investment is not suitable for all investors