General Dynamics: Undervalued With 10%-15% Upside

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 |  About: General Dynamics Corporation (GD)
by: Jeff Williams

Summary

What are the some of the key growth factors?

Which business segments will lead growth and how will they do that?

Looking forward, how will the different business segments valuations change? and what to expect valuation wise from them.

In spite of an extensive run in which General Dynamics (NYSE:GD) racked up gains of ~80% over the past year and a half, I believe the company still looks to be attractively valued.

In the article below, I will discuss some of the reasons why the stock is still attractive, assess how the company valuations should continue to increase and look at catalysts moving forward.

GD Chart

GD data by YCharts

One of the biggest factors leading to the stock appreciation over the past year and a half was that Jet Aviation became cash positive and returned to profitability. As Jet Aviation and Gulfstream are the two businesses behind the Aerospace segment, this result is expected to have a significant effect on the company's bottom line. As demand for new aircraft continues, interest in the company's older models remains strong, and new outfitting projects for Jet Aviation are increasing. This has resulted in a strong well-diversified backlog.

The strength behind the accumulated backlog is that it generally refers to an accumulation over time of work waiting to be done or orders to be fulfilled. As of Q2 2014, General Dynamics stated it has back-log orders of $71.1 billion and contract values of $28.4 billion, totaling back-log and contract values of $99.502 billion, ensuring strong revenues for the future.

U.S. Military Spending and Pursuance of International markets

Much like other companies with military ties, Lockheed Martin (NYSE:LMT), United Technologies (NYSE:UTX), and to a much lesser extent, Boeing (NYSE:BA), the group is looking to find resources outside the U.S. At current levels, United States is spending more than 3.5x as much as any other country on defense. U.S. defense spending equates to ~38% of all military spending globally, but as many countries are looking to increase spending, and the U.S. is looking to keep spending increases flat for the foreseeable future, creating a global web of investments outside the U.S. looks to be a logical plan for growth.

As a result of tightening the U.S. military budget, GD continues to focus on reducing its exposure to the U.S. government and turn its focus on increasing international and commercial sales. In 2013, 38% of the sales were generated from customers that were not the U.S. military. In 2012, 34% of sales were generated from commercial and foreign military customers. This trend looks to continue as Danny Deep, vice president at General Dynamics Land Systems stated:

The whole-of-government approach to export sales gives us a strategic advantage as we pursue international markets.

Looking forward, As the company focuses on commercial sales that are being fueled by the recovering business jet market, this looks to be providing a positive catalyst for the Jet Aviation and Gulfstream segments. Within Boeing's company presentation, the company stated it expects global growth to increase at ~3.2% over the next 20 years. This is creating a positive macro-economic tailwind General Dynamics Aerospace businesses.

The company the segment that I expect to drive earnings for the next few years is Aerospace. With the business airplane segments expecting to see increased growth and U.S. military spending to remain flat in the foreseeable future, I believe the bulk of growth will come from Aerospace.

Valuation Breakdown

Within the four business segments, I have calculated the terminal value of each business segment. Over the trailing twelve months, Aerospace, which includes Jet Aviation and Gulfstream, equates to ~39% of the company's total value. Combat Systems equates to ~24%, Information Systems & Technology equates to ~19% of the total value of the company, while Marine Systems equates to 18% of the company's total value.

Chart sourced (Stockresearching)

Looking forward, I believe some of the money will come out of the Aerospace / Defense sector. The major reason for this is U.S. military spending. Even though there are ample opportunities globally for companies within this sector, the U.S. equates to ~38% of global spending. At this point, I do not believe this will be a significant trend, but I believe does have a factor in GD being so undervalued. So, as the Aerospace / Defense sector currently trades at 11.23x EBITDA, I believe if I reduced the valuation of the trading range by ~5% calculating forward, this would be reasonable and conservative. Based on this looking forward estimate, I have the company trading at ~10.59x EBITDA.

FY2014 FY2014 FY2014
FY 2014 TTM 2% growth EBITDA 5% growth EBITDA Analyst Estimates FY 2014
Operating Income 3,721
Taxes 1,104
Unlevered Net income 2,617
D&A 540
EBITDA $4,261 $4,346 $4,474 $4,321
Free Cash Flow 2,876 2,876 2,876 2,876
WACC 9.86% 9.86% 9.86% 9.86%
Terminal Value 11.06X EBITDA 47,127 46,026 47,380 45,759
Sum of Parts $50,002.66 $48,902.47 $50,256.19 $48,635.39
Net Present Value $45,514.89 $44,513.44 $45,745.67 $44,270.33
Total Debt 3,910 3,910 3,910 3,910
Cash and Cash Equivalents 3,841 3,841 3,841 3,841
Net Debt $69.00 $69.00 $69.00 $69.00
Equity Value $45,445.89 $44,444.44 $45,676.67 $44,201.33
Shares Outstanding 334.32 334.32 334.32 334.32
Price Value $135.94 $132.94 $136.63 $132.21
Current Price 117.38 $117.38 $117.38 $117.38
Difference 15.81% 13.26% 16.40% 12.64%
Click to enlarge

Using the DCF above, there are a couple of results based on the projected earnings of General Dynamics.

1. Based on Q2 numbers, the stock is undervalued by ~15.81%. This is based on the company trading at 11.07X EBITDA.

2. Based on the rest of the year earnings growth of ~2%, disregarding any share buybacks in which management stated it would do, I have a value of $132.94 per share, or ~13.26% higher than the current stock value of $117.38. This is based on the company trading at a reduced 10.59X EBITDA.

3. Based on the rest of the year earnings growth of ~5%, disregarding any share buybacks, I have a value of $136.63 or, ~16.40% higher than the current stock value of $117.38. This is based on the company trading at a reduced 10.59x EBITDA

4. Analysts at 4-traders have a FY 2014 target EBITDA of $4.321 billion. With that estimate, I have a valuation of ~$132.21.

Based on company estimates ranging on FY 2014 sales in the $30.2 billion range and an operating margin of 12.5% for FY 2014, this equates to an operating income of $3.775 billion. In looking at the company buying back some shares in the second half of the year and a slightly reduced tax rate, I have to agree with analysts estimates and place the stock price value in the $132.21 representing ~12.5% upside.

In my opinion, concentrating on a global platform within the military segments will mitigate some of the risks that the company faces. As there is significant growth expected within in the airplanes businesses, I believe this will drive earnings within the Aerospace segment. In estimating that the Military side of earnings will remain flat while the Aerospace side of the company increases, I have a forward looking estimate in the $132.00 range or 12% upside from this point.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.