The threat of sequestration has cast a pall over defense contractor shares, especially General Dynamics (GD). Sequestration is the budget tactic that was agreed to in the Budget Control Act of 2011 that would lead to "cuts" in federal spending of $1.5 trillion over the next 10 years. The fear among the analyst community is that a disproportionate amount will be taken from the defense budget, especially with the Democratic Party in control of both the White house and the Senate.
As we can see from the chart below, the threat of automatic and potentially painful defense department cuts has led to General Dynamics underperforming the market as a whole. In the article below I will present 4 reasons to back my thesis that General Dynamics offers a compelling valuation at current levels.
Chart courtesy of BigChats.com. Date range is 8/2/2011 the day the Budget Control act of 2011 was signed to present. It compares the S&P 500 with the results of General Dynamics.
The first reason for my bullishness in General Dynamics is my belief that the fears of "sequestration" are overdone and fully reflected in the share price. Politicians have a way of finding an amicable solution when "their feet are pressed against the fire" and I see this as similar incidence. Defense cuts are not necessarily a partisan issue for the simple fact that they employ a large number of people throughout the country. A politician's party allegiance will be cast aside if he/she knows that a large defense employer resides in their respective district. It would be seen as political suicide if they would vote to allow the cuts to affect a large number of their constituents. The more likely outcome in my opinion is for a deal to be struck before the December deadline that is acceptable to both parties. There will be cuts made to the Defense department's budget, yet I believe they will be offset by allowing the companies to sell some of their technology and weapon systems overseas.
The second reason for my bullishness is how well run General Dynamics is. While researching General Dynamics, I studied their financials for the last 10 years to get an idea of how the company has grown and how it is run. General Dynamics has managed to average 18% plus return on equity for the last ten years while keeping its long term debt below 25% of its capitalization. Management has used the earnings generated to reinvest in other profitable lines and to purchase complimentary businesses without saddling the overall company with excessive debt. Management has been able to do this on consistent basis as evidenced by assets growing from $11.7 billion in 2002 to roughly $35 billion in 2011. The investment made in other profitable lines segues into my third reason which is diversification.
General Dynamics operates in four different distinct segments. The largest segment is known as Information Systems and Technology which was started in 1998. IS&T accounts for the largest portion of 2011 revenue (34%) and really illustrates how well managed the company is. The fact that it could leapfrog such legacy divisions such as combat systems and marine speaks of management's vision to broaden the company's revenue stream. The last division is aerospace which makes the Gulfstream jets. IS&T along with the Gulfstream business offers General Dynamics the greatest potential for future growth. The IS&T division works on cyber security along with wireless solutions which will likely be spared from any cuts at the bare minimum. A more likely scenario would be for this division to see further funding due to the changing landscape of modern warfare. The following quotes are attributed to Jay Johnson CEO of General Dynamics from the most recent conference call courtesy of Seeking Alpha.
IS&T business is experiencing the most pressure, due primarily to award delays on several of our key tactical communications contracts. In most cases, these are funded programs of record. While there are -- excuse me, while there was improvement in activity from first to second quarter, this order activity did not meet our expectations.
Sequestration has cause delays in awards actually allowed to go through. As the deadline nears I anticipate funding to be restored providing some nice revenue for General Dynamics.
As for the aerospace division,
In our Aerospace group, Gulfstream continues to enjoy a sizable, multi-year large cabin backlog in a robust order pipeline. The fidelity of our backlog is evidenced by the extremely limited default of activity this quarter. And point of fact, this was the lowest default quarter since the economic downturn began in 2008. We are seeing, however, some elongation of our business jet order cycle with a number of factors causing deal closure times to increase. In part, order delays, most of which materialize late in the quarter, reflect the decline in global economic sentiment.
I anticipate as time progresses the orders that were agreed upon will be accepted by the client realizing General Dynamics significant profits for years to come.
The final reason for an investment in General Dynamics is its above average dividend. General Dynamics is currently yielding above 3% and has consistently increased its dividend. For the last 10 years the dividend has increased from 59 cents a share to its current $1.83. With the shares currently trading at roughly 9 times this year's earnings, General Dynamics is hardly overvalued.
To summarize, an investment in General Dynamics currently offers a patient investor an above average and growing dividend. The shares are depressed due to the uncertainty over the US budget which should be resolved fairly soon. Once the budget is passed we will have more clarity into General Dynamics' future order flow which should be a positive catalyst for a much higher equity price.
Additional disclosure: Thank you for reading this article. The above information is for informational purposes only. I look forward to your comments.