- General Dynamics is a Dividend Aristocrat, and the current yield is above the market average.
- The dividend is well covered by earnings and free cash flow.
- The stock price has been beaten down during the recent market downturn. The stock trades well below the broader market average earnings multiple.
- General Dynamics recently won a large contract for the Virginia-class submarine.
Introduction and Thesis
We entered the year with the US stock market setting new highs. But the coronavirus has pummeled the market creating bargains in some stocks. We may still have more down days, but there are bargains to be had now. From this perspective, I am now writing about General Dynamics Corporation (NYSE:GD). The company is a Dividend Aristocrat that is undervalued. The stock is being impacted by not only the general downturn but also a declining backlog until recently. But with that said, General Dynamics is a Dividend Aristocrat having raised the dividend for 28 consecutive years. I consider the dividend safe, and it is growing at a decent clip. Furthermore, the company has market leading platforms in marine and land defense systems and business jets. Hence, I view the stock as a long-term buy.
Overview of General Dynamics
General Dynamics, which was founded in 1952, is primarily a manufacturer of combat platforms for the US DoD. It focuses primarily on nuclear submarines and armored vehicles. In addition, General Dynamics also has exposure to the commercial market with its business jet products. The company bought CRSA expanding its presence in IT. The company now operates in five business segments: Aerospace (23% of sales), Combat Systems (17%), Marine Systems (23%), Information Technology (23%), and Mission Systems (13%). The company makes the well-known M1 Abrams tank, Stryker vehicle, Virginia class submarine and Gulfstream business jets. Based on revenue, General Dynamics is the third largest defense company. General Dynamics had revenue of approximately $39.4B in 2019.
General Dynamics' Revenue and Margins
General Dynamics' revenue growth was in the doldrums until recently. But the recent acquisition of CRSA in 2018 boosted revenue as the company created a new business segment, Information Technology. In addition, business jet sales are trending up now due to new Gulfstream models, especially the G600, and the recently announced G700.
General Dynamics' top line growth is also tied to increasing volume of the mature M1 tank and Stryker vehicles. These are periodically updated with new more capable models. In addition, older models, which are in service for many years, need sustainment and modernization, and General Dynamics has a large worldwide installed base. But, with that said, most of the recent uptick in US defense spending has been focused on aerospace, cyber, missiles, and other areas where General Dynamics has little presence. This has caused the backlog in the Combat Systems and Marine Systems segments to decline and the backlog for Mission Systems to be flat. In fact, the book-to-bill ratio was below 1.0, meaning that the company was not replacing completed contracts with new contracts. This likely explains why General Dynamics stock price trades at a lower valuation than its peers.
But, with that said, General Dynamics had a major $22.2B contract win recently with the Virginia class submarine. Additionally, the Information Technology segment had large contract wins. The increase in backlog for these two segments, combined with a rise in orders for the Aerospace segment, has pushed the book-to-bill ratio to 1.5. The contract wins have also positioned General Dynamics to grow revenue and earnings per share for the next several years.
On the profitability front, General Dynamics exhibited upward trending margins until the CRSA acquisition. However, this deal lowered company-wide margins, which led to a decline in gross margins, operating margins, and net profit margins in 2018 and 2019. In fact, the Information Technology segment has the lowest margins at ~7.6% compared to the remaining four business segments. But with that said, margins for Information Technology should rise as the company improves operational efficiencies.
General Dynamics Dividend and Safety
General Dynamics has paid a growing dividend for 28 consecutive years, making it a Dividend Aristocrat and Dividend Champion. This makes the stock interesting to most dividend growth investors. The forward dividend is $4.08, and the recent market downturn has increased the yield to over 2.5%. This is greater than the broader market average of about 2.0%. Furthermore, the dividend is very safe from the perspective of earnings and free cash flow.
The payout ratio is only ~32.1% based on the forward dividend and consensus 2020 adjusted earnings per share of $12.71. This is an excellent value and well below my threshold of 65%. It also provides confidence that the dividend will not be cut even in a recession or during budget cuts. If we assume that the dividend grows at 5.5% per year and earnings per share grow at 6% per year for the next several years, then the payout ratio will be between 31% and 32%.
The dividend is also safe from a free cash flow perspective. In fiscal 2019, operating cash flow was $2,930M, and capital expenditures were $987M, giving free cash flow of $1,943M. The dividend required $1,152M. The dividend-to-FCF ratio was roughly 59%. This is a decent value and well below my threshold of 70%.
General Dynamics has a very conservative balance sheet, although the cash position is low. Short-term debt now stands at $2,920M, and long-term debt is at $9,010M at end of fiscal 2019. This was offset by only $902M in cash, equivalents, and marketable securities, which is not much. But, with that said, debt is declining as the company has paid down some short-term debt and long-term debt since the CRSA acquisition. Interest coverage is back up to ~10X, and the leverage ratio is about 2.2X. Note that these are not as good as recent trailing values before the CRSA acquisition. But if General Dynamics continues to pay down debt, then these numbers should go improve over the next couple of years.
General Dynamics' major risk is that a new or future program gets cut or the company fails to win major contracts. In this case, the book-to-bill ratio could drop below 1.0, which is not tenable over the long term. Defense budget fluctuations can also impact the company's top line and thus bottom line. General Dynamics has little control over this. The other major risk is that the business jet market has a major downturn. This happened during the Great Recession, and the market took many years to recover. These events would likely lead to a lower valuation.
General Dynamics' Valuation
Now, let's examine the valuation of General Dynamics. The forward price-to-earnings ratio based on consensus 2020 adjusted EPS of $12.71 is now about 12.7. This is below the trailing average over the past decade of ~14. It is also much lower than that of the broader market. We will use 14.0 as the earnings multiple to determine the fair value of $177.94. Applying a sensitivity analysis using P/E ratios between 13.0 and 15.0, I obtain a fair value range from $165.23 to $190.65. The current stock price is ~64% to ~97% of my estimated fair value. The current stock price is ~$161.05, suggesting that the stock is undervalued.
Estimated Current Valuation Based On P/E Ratio
% of Estimated Value at Current Stock Price
Source: dividendpower.org Calculations
How does this compare to other valuation models? Morningstar is known to use a fairly conservative discounted cash flow model and provides a fair value of $188. The Gordon Growth Model gives a fair value of $163.20, assuming a desired return of 8% and dividend growth rate of 5.5%. An average of these three models is ~$176.30 suggesting that General Dynamics is undervalued at the current price.
How does General Dynamics compare to other aerospace and defense contractors? We make the comparison to three other companies: Northrop Grumman Corporation (NOC), Raytheon Company (RTN), and Lockheed Martin Corporation (LMT). One can see from the comparison that General Dynamics is probably undervalued relative to its peers.
Technical Comparison of Valuations
Price-to-earnings ratio [FWD]
Source: Dividend Power and Seeking Alpha
General Dynamics is a very safe stock. The company has the advantages of being an entrenched defense contractor making bespoke and classified platforms for the US DoD. Morningstar gives it a wide economic moat with a stable trend. Value Line gives the stock a financial strength rating of 'A++', a stock price stability of 90, and an earnings predictability of 100. General Dynamics' credit rating was lowered to 'A2' by Moody's and 'A+/A-1' by S&P, which are decent investment grade ratings. The Dividend Power score is 9.13 [out of a scale of 9.0] due to the double-digit dividend growth, and relatively low valuation payout ratio. This is a good value.
Final Thoughts On General Dynamics
General Dynamics is one of the few large defense contractors after industry consolidation. The stock has not really participated in the bull market in aerospace and defense stocks due to a declining backlog, the CRSA acquisition, and higher debt. But that recently changed as the backlog ticked up and debt is being paid down. The stock is a Dividend Aristocrat with some attractive characteristics, including a decent yield, low payout ratio, good dividend growth rate, and relatively low valuation. There is some risk with the company due to the cyclical nature of the business jet market. Additionally, future defense program could be cut. But, in general, the positives outweighs the negatives here. Hence, I view the stock as a long-term buy.
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This article was written by
Analyst’s Disclosure: I am/we are long GD, LMT. 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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