General Dynamics: Short-term Uncertainty, Long-term Opportunity?
General Dynamics (GD) is a leading business aviation, combat vehicle, weapons, marine and information system company. Founded in 1952, General Dynamics has integrated and acquired more than 60 different businesses - growing revenues to about $32 billion and employing approximately 95,000 employees today.
The company's sales are divvied up roughly equally between four basic areas. Specifically aerospace makes up about 22% of yearly revenue, combat is 26%, information and systems technology at 31% and marine coming in at 21% of annual sales. Given this, it should not be much of a surprise that the firm gets about two-thirds of its business from the U.S. government. In other words, if anyone should be concerned with the government shutdown hoopla, it's General Dynamics.
Morningstar analyst Neal Dihora describes General Dynamics' risk well:
"General Dynamics faces significant uncertainty from government decisions as it generates nearly 66% of sales from the various U.S. government agencies. Further, defense procurement is a lengthy and often politicized process that swings with the priorities of the administration in power."
In turn, a current investor - or one considering the partnership - would expect that management is on top of this situation. And this is precisely what we see. In General Dynamics' most recent earnings call General Dynamics' CEO Phebe Novakovic indicated the following with regard to the government shutdown:
"This is not news to anybody; the government took the nation to the edge on the debt ceiling extension. And in my mind, we were forced to gaze into the abyss, where we saw the full faith and credit of our principal customer at risk. That was sobering and suggests that we need to be cautious with cash as we finish the year and move into next... I think it is premature to assume that the conditions cannot repeat in January... So I think all of that suggests that we need prudence and caution as we move into the rest of the year and the beginning of next year, until we can get a more stable plan from the government with respect to both the debt ceiling and funding for our principal customer."
With the stock trading below a 15 P/E multiple for the last half decade, it would seem as though the market is also waiting for this more stable plan. Yet it's important to underscore the idea that management is well aware of the situation at hand. While this by itself would not reassure a potential investor, future comments with this information in hand might. For instance, Phebe Novakovic also offered the following:
"Let me turn to our EPS guidance for the remainder of 2013. Last quarter, we increased our guidance to $6.85 to $6.95 of earnings per diluted share. We are again increasing our guidance somewhat to $6.90 to $7... I think our guidance is not overly cautious and [is] consistent with the current environment."
Despite the potential for a looming government debacle, General Dynamics is still relatively optimistic. Now, I don't want to take away from the true risk of government dependence. It's a risk that should not be overlooked. Yet if one's investment thesis supports a reasonable continuation of future business prospects, then I would advocate that there might be several lasting positives.
First and foremost, the stock has been somewhat out of favor; or as Warren Buffett would indicate:
"Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well."
If the future were clear, the prospective opportunities for General Dynamics rosy, then it would follow that the stock would likely be trading at a premium valuation. Instead, we see the exact opposite. Perhaps this is well founded, but then again, there is a more upbeat possibility for the long-term investor who believes in the enduring prospects of the company.
As an addendum to this point, it's always good to place one's investing decision in context. For instance, if General Dynamics is only able to grow at 2% for the next 5 years - roughly a third of the analysts' consensus - and trade at a 15 multiple, this would indicate an 8% annual compound growth rate including dividends. Perhaps your expectations are higher or lower, but in a general sense the business doesn't have to do anything that spectacular. Or looking at the prospects of the company from a different angle, perhaps you believe the cost cutting measures will take hold or that the aerospace segment will make up for the lackluster performance in other areas. That is, you generally believe in the business.
Finally, General Dynamics has shown a great propensity to reward shareholders. General Dynamics has not only paid but also increased its dividend for 22 consecutive years. In the past decade these increases have come in at a tune of about 13% a year. In addition, the company has done a great job of reducing share count - in the past 13 years General Dynamics went from having about 401 million shares outstanding to today's number closer to 349 million.
Overall, the point is not that General Dynamics is a riskless, must-buy investment. Rather, there's usually a reason why the stock price doesn't necessarily reflect the business results of the company in the short-term. Your job is to determine whether or not these concerns are warranted or near-sighted. With that being said, let's move on to the operating results of the company.
15 Years of Growth
General Dynamics has grown earnings (orange line) at a compound rate of 11.1% since 1999, resulting in a 30.9+ billion dollar market cap. In addition, General Dynamics' earnings have risen from $2.17 per share in 1999, to today's forecasted earnings per share of approximately $6.95 for 2013. Further, as noted, General Dynamics has been increasing its dividend (pink line) for the past two decades and has been able to increase this payout at a robust pace.
For a look at how the market has historically valued General Dynamics Corp, see the relationship between the price (black line) and earnings of the company as seen on the Earnings and Price Correlated F.A.S.T. Graph below.
Here we see that General Dynamics' market price previously began to deviate from its justified earnings growth; starting to become undervalued during the most recent recession and staying somewhat undervalued in the years to follow. Today, General Dynamics still appears undervalued in relation to both its historical earnings and relative valuation.
In tandem with the strong earnings growth, General Dynamics' shareholders have enjoyed a compound annual return of 8.9% which correlates fairly closely with the 11.1% growth rate in earnings per share. A hypothetical $10,000 investment in General Dynamics on 12/31/1998 would have grown to a total value of $35,264.11, without reinvesting dividends. Said differently, General Dynamics' shareholders have enjoyed total returns that were roughly 2 times the value that would have been achieved by investing in the S&P 500 over the same time period. It's also interesting to note that an investor would have received approximately 2 times the amount of dividend income as the index as well.
But of course - as the saying goes - past performance does not guarantee future results. Thus, while a strong operating history provides a fundamental platform for evaluating a company, it does not by itself indicate a buy or sell decision. Instead, an investor must have an understanding of the past while simultaneously thinking the investment through to its logical, if not understated, conclusion.
In the opening paragraphs a variety of opportunities and risks were described. It follows that the probabilities of these outcomes should be the guide for one's investment focus. Yet it is still useful to determine whether or not your predictions seem reasonable.
Twenty-one leading analysts reporting to Standard & Poor's Capital IQ come to a consensus 5-year annual estimated return grow rate for General Dynamics of 5%. In addition, GD is currently trading at a P/E of 12.9, which is inside the "value corridor" (defined by the orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, General Dynamics' valuation would be $131.82 at the end of 2018, which would be a 10.5% annualized rate of return including dividends. A graphical representation of this calculation can be seen in the Estimated Earnings and Return Calculator seen below.
Now, it's paramount to remember that this is simply a calculator. Specifically, the estimated total return is a default based on the consensus of the analysts following the stock. The consensus includes the long-term growth rate along with specific earnings estimates for the next two upcoming years. Further, the dividend payout ratio is presumed to stay the same and grow with earnings. Taken collectively, this graph provides a very strong baseline for how analysts are presently viewing this company. However, a F.A.S.T. Graphs' subscriber is also able to change these estimates to fit their own thesis or scenario analysis.
Since all investments potentially compete with all other investments, it is useful to compare investing in any prospective company to that of a comparable investment in low risk treasury bonds. Comparing an investment in General Dynamics to an equal investment in a 10-year treasury bond, illustrates that GD's expected earnings would be 4 times that of the 10-year T-Bond Interest. This comparison can be seen in the 10-year Earnings Yield Estimate table below.
Finally, it's important to underscore the idea that all companies derive their underlying value from the cash flows (earnings) that they are capable of generating for their owners. Therefore, it should be the expectation of a prudent investor that - in the long-run - the likely future earnings of a company justify the price you pay. Fundamentally, this means appropriately addressing these two questions: "in what should I invest?" and "at what time?" By viewing the past history and future prospects of General Dynamics Corp we have learned that it appears to be a strong company with reasonable, yet risky upcoming opportunities. However, as always, we recommend that the reader conduct his or her own thorough due diligence.
Disclosure: Long GD at the time of writing.