General Dynamics: New Accounting Rule Clouds Sunny Medium Term Outlook

| About: General Dynamics (GD)

Summary

GD provided a medium term outlook that features strong revenue growth and profit margin expansion.,.

The outlook also features balanced performance across all four of GD's business segments.

New accounting rules will make it difficult for investors to evaluate the outlook.

Investors reacted favorably to the outlook, but there may be more upside if management can execute.

General Dynamics Corp.'s (NYSE:GD) management team provided investors with a much awaited medium term outlook, but the company also threw them a curve ball. New accounting rules will change how GD recognizes revenue and earnings. Since GD is only restating results for 2016, the firm's historical results are less useful in discerning trends. Against this cloudy backdrop, GD painted a bright picture for both revenue and earnings. Although the market reacted favorably to the outlook, a reasonable valuation suggests there may be more upside for investors if management can deliver the revenue and earnings growth it is forecasting.

Material Impact from New Accounting Rule

Investors in GD need to understand the implications of the firm's implementation of Accounting Standards Codification Topic 606 (Topic 606). Topic 606 addresses revenue and earnings recognition from long-term contracts. GD will implement Topic 606 on January 1, 2017. During the earnings call for 4Q16, management identified two ways that where Topic 606 will have a material impact

When GD determines that there has been a change in its estimate of the total revenue and profits from a long-term contract, it will recognize the full amount of the change immediately instead of its current practice of allocating the change over future periods. Topic 606 instructs aerospace firms to recognize revenue when they deliver an outfitted plane. GD's current practice is to recognize a portion of the revenue from an aircraft when they make what the industry calls a green delivery or unfurnished.

The tables below demonstrates that investors would conclude management expects GD's revenue and operating earnings to contract in 2017. However, the company's forecast for next year projects 3% top line growth and an 11% increase in the bottom line after adjusting for the impact of Topic 606.

Revenue

Reported

Topic 606 Impact

Growth

2017F

Growth %

Aerospace

8,362

(547)

535

8,350

6

Combat Systems

5,602

(262)

355

5,695

6

Information Systems

9,187

(43)

174

9,318

2

Marine Systems

8,202

(130)

(172)

7,900

-2

Total

31,353

(982)

892

31,263

3

Operating Earnings

Reported

Topic 606 Impact

Growth

2017F

Growth %

Aerospace

1,718

(311)

193

1,600

12

Combat Systems

914

(83)

89

920

10

Information Systems

992

(51)

84

1,025

8

Marine Systems

725

(130)

85

680

13

Elimination

(43)

3

0

(40)

0

Total

4,306

(572)

451

4,185

11

Source: GD 8-k filing for 4Q16

The new accounting rule has a more pronounced negative impact on GD's operating earnings in 2016 than its revenue. Consequently, GD's operating margin for 2016 after restating results per Topic 606 is 143 basis points (bps) lower than the operating margin as reported. It is important to remember that Topic 606 has no impact on the economic profit or timing of cash flows from long-term contracts. Management's forecast for 2017 implies an operating margin that is more than 100 bps greater than GD's operating margin for 2016 restated per Topic 606. Investors should focus on this improvement.

Reconciliation of Operating Margin

Favorable Five Year Outlook

Investors cheered the guidance that GD management provided for 2017 and annual growth rates for the five-year period beginning in 2016. GD's shares rose more than 4% the day it released earnings and communicated its medium term outlook. This strong, positive reaction was most likely due to the medium term outlook not earnings for 4Q16. The earnings release did not contain the information about the medium term outlook, and the shares opened slightly lower after the earnings release. During the conference call, the shares moved upward as management communicated guidance.

The chart below illustrates three key points regarding GD's medium term outlook.

Consolidated revenue growth will be strong at 5.6% per year. The forecast implies a one percentage point expansion in operating margin because the annual growth rate for operating profits of 7.1% exceeds the annual growth rate for revenue of 5.6%. The growth is balanced across business segments with each segment expected to achieve at least 4% average annual growth in revenue and profit margin expansion.

Annual Growth Rate for 2016-2020

Assessment of Management's Outlook

Assessing GD's medium term outlook will be difficult for investors. Management provided minimal details around the drivers of strong growth through 2020. Second, Topic 606 confounds trend analysis. However, there are several factors to support strong factors over the next four years.

The launch of the Gulfstream G500 and G600 should facilitate strong growth at aerospace. Since GD only recognizes revenue when it delivers an outfitted aircraft, green deliveries become a leading indicator of revenue. There were 128 green deliveries in 2016 compared with 115 outfitted deliveries. This difference suggests potential for strong revenue growth in 2017. During the earnings call for 3Q16, Phebe Novakovic highlighted that combat systems' was poised to report strong revenue growth because it had several contracts moving into the production phase, including Canada and the Middle East as well as the Ajax armored vehicle. The Navy is replacing its Ohio class of ballistic missile submarines with Columbia class, and this project will generate significant revenue for GD's marine segment. The dollar, which has been a headwind for many of GD's product, is unlikely to strengthen further.

There are a couple antitheses to GD's growth story. First, Honeywell's report on the aviation industry projected a 6% downward trend in aircraft deliveries over the next 10 years. The report cites aircraft manufacturers' plans to transition to new models and lackluster macroeconomic growth. While GD is further along in its launch of next generation aircraft, a sluggish global economy is a concern.

Concerns about defense spending is the second counterargument to GD's projections for strong growth. Spending by the U.S. Department of Defense (NYSEARCA:DOD) is a key source of revenue for GD. DoD's budgets have been volatile, and recent outlays are significantly less than the department's spending in 2011 and 2012. Even if the Trump administration and republican congress make defense spending a priority, GD faces two headwinds. Many experts believe the U.S. needs to direct spending towards intelligence gathering and away from traditional military equipment, like aircraft, tanks and submarines. Second, the Trump administration has signaled that it plans to be a tougher negotiator with government contractors than past administrations. The best example is the Trump administrations efforts to convince Lockheed Martin, one of GD's competitors, to lower the cost of the F-35 aircraft 1

.

Department of Defense Spending

Source: Department of Defense

Valuation

The following valuation uses management's outlook as the expected scenario through 2020. Since management's outlook anticipates a growth rate that is not sustainable in the long-term, it is appropriate to use a two stage discounted cash flow model to value GD. The first stage covers management's outlook, which is 2017-2020. The second stage covers the period after 2020, and it can be valued as a growing perpetuity.

Below are the key assumptions for the first stage.

Management's guidance on average annual growth rate for operating earnings for the next five years CFO's assertion on the 4Q16 earnings call that net earnings will approximate free cash flow (NYSE:FCF) in most years Tax rate of 28% which is management's prediction for 2017 Levered beta of 0.91 from Yahoo Finance Cost of debt of 3.0% based on data from Moody's on current yield for intermediate debt rated 'A' Debt to enterprise value of 6% based on current market values Risk free rate of 2.5% based on yield of 10 year U.S. Treasury from U.S. Treasury website. Market risk premium of 5.7% from website of New York University Professor Aswath Damodaran, who specializes in valuation

Below is the calculation of the weighted average cost of capital (OTC:WACC), which applies to both the first and second stages.

WACC = r Equity* (1 - Debt / Enterprise Value) + r Debt* Debt / Enterprise Value * (1 - Tax Rate)

r Equity= Risk Free Rate + Beta GD * Market Risk Premium = 2.5% + 0.91 * 5.7% = 7.7%

WACC = 7.7% * (1 - 6%) + 3.0% * 6% * (1 - 28%) = 7.4%

The present value of the first stage is approximately $11 billion. The table below provides the details by year.

($ millions)

2016

2017

2018

2019

2020

Operating Earnings

3,734

4,185

4,419

4,665

4,925

Taxes @ 28%

1,046

1,172

1,237

1,306

1,379

Net Earnings / FCF

2,688

3,013

3,181

3,359

3,546

Discount Rate

0.93

0.87

0.81

0.75

Discounted FCF

2,807

2,760

2,715

2,670

Note: Discount Rate = 1 / (1 + WACC)^t

The second stage only requires two assumptions. First, the WACC remains 7.4%. Second, the long-term growth rate is 2.0%. Management did not provide any guidance for growth after 2020. The selection of 3.0% is moderately conservative. Management expects GD's earnings to grow at more than 7% in the years prior to the second stage. However, it is difficult for companies to grow faster than the sum of real GDP growth and inflation in the long-term.

PV of FCF 2nd Stage= [FCF 2020* (1 +g Long term) ] / (WACC - g Long term) * (1 / (1 + WACC)^t

PV of FCF 2nd Stage= {[$3.5 billion * (1 + 3.0%)] / (7.4% - 3.0%) } * 1 / (1 + 7.4%)^4 = $61.5 billion

The two stage model results in a price per share of $221. This price is an 18% premium relative to GD's current price. One possibility is that investors are skeptical of management's outlook. In that case, investors who believe management's forecast is reasonable should buy GD. On the other hand, valuations are very sensitive to terminal growth assumptions. Lowering the long-term growth rate to 2% from 3% reduces the share price to $183, which is a few dollars below where it is trading today.

2% Long-term Growth

3% Long-term Growth

Stage 1 FCF ($ billions)

11

11

Stage 2 FCF ($ billions)

49.7

61.6

Share Price

221

183

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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