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General Dynamics (GD) is a market leader in the aerospace and defense industry. It competes with companies such as Boeing (BA), Lockheed Martin (LMT), and Northrop Grumman (NOC). The company is divided into four business groups.

  1. Aerospace: Includes the Gulfstream Aerospace group, which builds business jets. Made up 19% of total revenue in 2011.
  2. Combat Systems: Creates tracked and wheeled military vehicles, weapon systems, and munitions for the United States and its allies. Made up 27% of total revenue in 2011.
  3. Marine Systems: A leading U.S. shipbuilder servicing the United States Navy and commercial customers. Made up 20% of total revenue in 2011.
  4. Information Systems and Technology: Tactical communications systems, information technology services and intelligence, surveillance and reconnaissance systems. Made up 34% of total revenue in 2011.

In 2011 69% of total revenue came from the United States government, with 12% from U.S. commercial customers, 9% from international defense customers, and 10% from international commercial customers. This heavy reliance on US defense spending means that cuts to defense spending could have a significant impact on General Dynamics' business.

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General Dynamics stock currently trades at $71.80, with a 52-week range of $53.95-$75.93. Let's take a look at the financials:

(In Million $)20072008200920102011
Revenue$27,240$29,300$31,981$32,466$32,677
Operating Cash Flow$2,925$3,110$2,840$2,986$3,238
Capital Expenditure$-474$-490$-385$-370$-458
Free Cash Flow$2,451$2,620$2,455$2,616$2,780

Both revenue and free cash flow have been slowly, steadily increasing over the last five years, with capital expenditures remaining essentially constant.

Owner Earnings

Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate Owner earnings by taking the 5-year average capital expenditure and subtracting that from the operating cash flow. I'll also subtract stock-based compensation from the operating cash flow since it has a dilutive effect on the company but is routinely included in the cash flow figure. I'll also add interest payments adjusted for taxes since interest is tax deductible.

(In Million $)20072008200920102011
Operating Cash Flow$2,925$3,110$2,840$2,986$3,238
Interest Payments$131$133$171$167$155
Stock-based Comp.$86$105$117$118$128
Avg Capital Expenditure$-436$-436$-436$-436$-436
Owner Earnings$2,493$2,661$2,404$2,548$2,780

Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine General Dynamics' Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.

(In Million $)20072008200920102011
Owner Earnings$2,493$2,661$2,404$2,548$2,780
Invested Capital$25,733$28,373$31,077$32,545$34,883
CROIC9.69%9.38%7.74%7.83%7.97%

General Dynamics' CROIC was about 8% in 2011, which means that given, say, $1 million in invested capital (retained earnings for example) the company will generate $80,000 in cash from that investment. CROIC is generally how fast a company will grow in the long term. Here's the balance sheet.

Cash and Cash Equivalents$2,649
Investments$0
Debt$3,930
Pension Obligations$0
Minority Interest$0
Net Cash (Debt)$-1,281
Diluted Float362
Cash/Share$-3.53

General Dynamics has $2,639 million in cash and investments compared to $3,930 in debt and debt-like obligations, which leaves $3.53 in net debt per share. Interest payments made up only 5.6% of owner earnings in 2011, so the debt level is not concerning.

Valuation

I use a discounted cash flow analysis to determine the fair value of a company. I use a discount rate of 15%, and you can read about my view on discount rates here. Average analyst estimates put the 5-year earnings growth at 8.65%. I will set the initial owner earnings growth rate to 6% and allow that growth rate to decay over 20 years to a perpetual growth rate of 3% according to the growth table below.

Year12345678910
%6%5.85%5.7%5.55%5.4%5.25%5.1%4.95%4.8%4.65%
Year11121314151617181920
%4.5%4.35%4.2%4.05%3.9%3.75%3.6%3.45%3.3%3.15%

Using these parameters I arrive at a fair value of $74.83, which is close to the current market price, meaning that General Dynamics is fairly valued at these prices. A table of buy targets for various margins of safety are listed below.

Margin of SafetyBuy Target
10%$67.35
15%$63.61
20%$59.87
25%$56.13

Conclusion

General Dynamics is currently fairly valued, but with the uncertainty in defense spending and the companies fairly low efficiency (CROIC) I would require at least a 25% margin of safety. Defense contractors in general are fairly risky investments at this time due to the uncertainty in defense spending, but once the fog clears GD may become a good choice.

Source: General Dynamics: Fairly Valued With High Uncertainty