Introduction
It's shouldn't be a surprise to a lot of readers that I'm bullish on aerospace & defense companies. Especially companies like the General Dynamics Corporation (NYSE:GD), which I have covered twice in recent history, here and here. The beautiful thing about General Dynamics is that it offers fantastic insights into the aerospace industry thanks to its commercial exposure. Even better is that the company has anti-cyclical defense-related exposure due to its exposure in maritime, combat systems, and advanced technologies. In this article, I will discuss the most recent earnings release and update my call to buy the stock as a long-term dividend growth investment. So, bear with me!
Things Are Improving Thanks To Aerospace
The two numbers that hit the wires first after the earnings release (revenue and EPS) came in as expected. The company managed to report rather unchanged sales of $9.22 billion and GAAP EPS of $2.61. That's $0.07 above expectations while sales missed by just $100 million - which is neglectable.
Source: Seeking Alpha
Despite flat sales growth, the company had a fantastic quarter. Thanks to a 140 basis points improvement in operating margins, the company was able to boost operating earnings by 15.0%, or $125 million, to roughly $960 million. The company also improved operating cash flow by $272 million. Due to lower capital expenditures ("CapEx"), free cash flow was boosted by more than $321 million.
Source: General Dynamics 2Q21 Earnings Presentation
Before I elaborate on free cash flow - and its many uses - it's both interesting and important to discuss how well aerospace did in the second quarter.
First of all, the sales number looked bleak as sales declined by $352 million to $1.6 billion. That's a 17.8% decline. However, that's where the bad news ends as it is only the result of fewer deliveries (as that's when revenue is generated). Last year, the company cut production to deal with supply chain uncertainties and lower expected demand as a result of the pandemic. Nonetheless, thanks to higher margins (+390 basis points) of 12.0%, operating earnings rose by 22.6% to $195 million. And we're still not finished with the good news. Orders in this segment are rising rapidly. The book-to-bill ratio is currently at 2:1. The Gulfstream alone has a 2.1:1 ratio. That's in dollars. In units, it's even better according to the company. What this means is that orders are twice as high as production numbers. This indicates significant sales growth ahead in this (mainly) cyclical business segment.
People have learned to deal with the pandemic, the economy is back on track, and (very) wealthy people are eager to spend their money on cool toys while businesses invest in business jets again.
Marine systems reported higher sales, better margins, and as a result higher operating income. In this case, sales were up 2.6%. Operating earnings improved by 5.0% thanks to a 20 basis points improvement in margins. The company benefited from i.e., stable submarine construction and saw modest growth in its total backlog compared to prior-year levels.
When looking at the bigger picture, we see that after minor weakness, Aerospace is now the only segment with significant backlog growth. All other segments are stable. This resulted in a book-to-bill ratio of roughly 1:1 and a modest increase of $95 million in the total backlog, pushing its value to almost $90 billion.
Source: General Dynamics 2Q21 Earnings Results
I'm not worried that the backlog is stable at all. General Dynamics is not a high-growth business - and it hasn't been for more than a decade. What matters is that its products continue to do well, and that's the case. Its Abrams main battle tank demand is increasing while the Stryker remains the combat vehicle of choice for multiple U.S. Army missions and operations. Meanwhile, the mission systems segment continues to be a bit weaker due to the sale of its space and tenant business last year, and the ongoing shortage of chips and other products.
There's A Lot Of Value
As I just mentioned, GD is not a source of growth. The company has moved from growth to value over the past >10 years. And that's OK as nobody is pretending that we're dealing with high growth over here. The company's growth comes from a high defense budget and international tensions that warrant investments in military equipment. For example, the company mentioned the need for Poland to invest in new battle tanks as tensions in the area increase. And that's just one of many examples.
As the graph below shows, in 2008 the company did roughly $4.0 billion in EBITDA. In 2022, EBITDA is expected to reach $5.3 billion. That's roughly 1.9% per year.
Source: TIKR.com (Includes 2021/2022 expectations)
However, that's where the bad news ends. The company is now able to generate close to $3.5 billion in free cash flow. That's a 6.3% FCF yield based on a $55.9 billion market cap. In other words, if the company were to spend all of its 2022 FCF on dividends, that's the yield investors would get.
Right now, the company needs roughly $1.3 billion to sustain its annual dividend (2.3% yield), which implies that there is a lot of room to grow its dividends. On top of that, net debt is back below 2.0x EBITDA, which means that the focus remains on shareholders as financial stability is not an issue.
Hence, in March, the company raised its dividend by 8.2%.
This raise was above last year's hike and continues the company's impressive - uninterrupted - dividend growth streak that has caused dividends to more than double since 2012.
Source: TIKR.com
On top of that, the company uses excess cash to repurchase shares. In 2Q21, the company repurchased shares worth $593 million.
As a result, the company has returned roughly 275% to its shareholders over the past 10 years - on a total return basis. That's below the S&P 500, but not by a lot. Keep in mind, GD is a stock with almost flat long-term EBITDA growth, a >2% yield operating in a rather stable environment. This company is competing with an index that is overweight tech with FANG+ stocks dominating its top 10 holdings.
It also helps that the company is not overvalued. Using a market cap of $55.9 billion and roughly $10.0 billion in expected net debt. That gives us an enterprise value of roughly $65.9 billion. That's roughly 12.4x 2022 EBITDA. Additionally, GD's dividend yield is roughly 100 basis points above the S&P 500 yield, which is an interesting bonus given that GD's dividend growth is high - otherwise, the higher yield would not be a benefit, in my book.
Takeaway
General Dynamics is a fantastic stock despite its slow growth in EBITDA and even free cash flow. I think this stock really classifies as a value stock because it is able to deliver high value now instead of somewhere in the future. The company has a >6% FCF yield, a dividend yield of more than 2%, a very stable business model, an extremely big and stable backlog, and a tailwind from rebounding aerospace demand.
I doubt that GD will outperform the S&P 500 on a long-term basis, but if you're looking for a sustainable dividend and a somewhat satisfying dividend yield, I think GD is a good addition to your portfolio - especially because the stock isn't overvalued.
(Dis)agree? Let me know in the comments!
