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General Dynamics (NYSE:GD) is an aerospace and defense company that supplies weapons, ammunition, combat vehicles, aircrafts, information systems and technology, and other defense related products and services. A brief description can be found here. The company was founded in 1899 and is based in Falls Church, Virginia.

The stock is rated "4.5 star" by GuruFocus for business predictability. Stocks rated "4.5 star" have average 10.6% annual return, with 10% of them still in loss if held for 10 years. The company's long-term debt issues receive an A rating from S&P, with a stable outlook. An 'A' ratings means the company is financially strong, but may be susceptible to adverse economic conditions. The stock has a beta of 1.25, which means its volatility is about 1.25 times that of the S&P 500.

Insiders have been selling the stock

In the past six months, there have been 11 insider sales (at prices ranging from $67.11 to $73.85) and no buys. The stock currently trades around $64, so the insiders were prescient in selling the stock. As insiders may have many reasons to sell unrelated to the stock's fundamentals, this is not necessarily a bad sign. To be fair, further examination is needed.

Value

For the trailing twelve months, the stock has $6.85 earnings per share, $90.16 revenue per share, and $8.00 free cash flow per share. At around $64 per share, the stock has a P/E of 9.3, a P/S of 0.71, and a P/FCF of 8. All these ratios suggest the stock is cheap right now. P/E less than 12-15, P/S less than 1, and P/FCF less than 10 are favorable ratios in general.

The book value is $38.53 based on the most recent quarter (ended March 2012), for a price to book ratio of 1.7. Although value stocks preferably have P/B less than 1, a P/B of 1.7 is not unreasonable. All of GD's ratios are lower than those of the industry or the S&P 500, as can be seen here. The stock's indicated dividend is $2.04, which is 3.2% yield. GD has increased its annual dividend rate for 15 consecutive years.

Looking at the stock's 10-year summary, we see that its P/E has ranged from a low of 9.2 to a high of 17.1, with the stock currently trading at the low range of its valuation. Its price to book ratio has ranged from 1.79 to 3.07 over the past 10 years, and again the stock's current P/B of 1.7 is at the low range of its valuation. The dividend yield has ranged from 1.2% to 2.8%, so the current yield is very high for this stock and confirms that the stock is selling at significant value to its historical valuation.

The current payout ratio is $2.04/$6.85 = 30%. In general, the lower the payout ratio, the better, so the company can retain more cash for reinvestment and provide for future growth. Low payout ratio (less than 50%) also means that the dividend is less likely to get cut and there is more room for dividend increases. For the past 10 years, GD's payout ratio has never exceeded 30%.

General Dynamics appears to be a solid value stock, but what about growth?

Growth

GD's revenue per share has grown from $34.41 in 2002 to $91.76 in 2011, for a 11.5% compounded annual growth, which is pretty impressive. Free cash flow per share has grown from $2.14 in 2002 to $7.81 in 2011, for a 15.5% compounded annual growth, again very solid growth. Earnings per share have grown from $2.28 in 2002 to $6.94 in 2011, for a 13.2% compounded annual growth.

General Dynamics looks like a fabulous growth stock. The most important growth parameter, however, is book value per share, which has grown from $12.94 in 2002 to $34.16 in 2011, for a 11.4% compounded annual growth, again a very strong growth rate. GD looks promising as both a value stock, as well as a growth stock.

Discounted Cash Flow

Assuming the lowest of the growth rates above, which is 11.4%, over the next 10 years, applying a discount rate of 12%, and assuming a terminal growth rate of 3%, we get an intrinsic value of $147, which provides a generous 56% margin of safety from the current price of $64.

Financial Strength

A more important consideration than potential reward for an investment is safety, as evidenced by the company's financial strength. One of the most important ratio in evaluating financial strength is the debt to equity ratio. On the most recent balance sheet (April 1, 2012), GD had $3,905MM in debt and $13,854MM in equity, for a 0.28 ratio, a very favorable ratio. In general, a D/E ratio less than 1 is good, and the lower, the better.

Another important ratio is the interest coverage, or times interest charges are earned. Again, the higher this ratio, the better, and anything above 6 to 1 indicates significant financial strength. In 2011, GD had an operating income of $3,628MM and interest expense of $141MM, for an interest coverage of 27, a sign of strong financial health.

A third financial ratio to look at is the current ratio, which is the ratio of current assets to current liabilities. A company with a current ratio less than 1 may be at risk of running into liquidity problem in the short term. Unlike the two financial ratios mentioned above, a current ratio that is too high is also unfavorable, and may indicate that the company is letting too much cash sitting around idly. For the latest quarter, GD has $15,510MM in current assets and $10,953MM in current liabilities, for a current ratio of 1.4, which is good.

It must be noted, however, that the $13,854MM in equity includes $15,542MM in intangible assets. Subtracting out the intangible assets leaves a tangible book value of -$1,688MM, or -$4.68 per share. Intangible assets are difficult to value and are not readily marketable, so if the company were to liquidate today (unlikely as long as the company is still generating positive cash flow), shareholders would be left nothing. The negative tangible book value also means the D/E ratio should be viewed with caution.

Potential Risks

As much as 69% of GD's revenue derives from the the U.S. government, which can be negatively impacted by U.S. defense spending cuts. Any such cuts, however, will probably be short-lived and unlikely to have long lasting effects on GD's business.

General Dynamics also faces competition from Boeing (NYSE:BA), Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), Raytheon (NYSE:RTN), etc, for government contracts. Government contracts are subject to termination and audits. As comparison with industry peer shows, GD has better margins, growth, and financial strength than most of its competitors and those of the industry, and yet trades at better or comparable valuations. This bodes well for the stock.

Conclusion

In summary, General Dynamics is a strong company that seems to be doing fine at the present, while trading at appealing valuations given the low market expectations. The growth rate is excellent, but may slow down a little looking forward. The current price is indicative of a bargain, trading at a significant discount below intrinsic value. Overall, General Dynamics would make a good addition to a well-diversified portfolio as a long-term holding.

Source: General Dynamics: A Good Combination Of Value And Growth

Additional disclosure: I may initiate a long position in GD in the near future.