GD - General Dynamics: Opportunity To Buy An Undervalued Major Federal Contractor With Competitive Dividend Yield

2023-08-11 04:19:52 ET

Summary

• General Dynamics gets a Buy rating today, in line with the analyst consensus.
• Positives: Valuation below sector average, dividend yield above sector average, capital strength & viability, share price vs 200-day average is at good point. Also is a leading federal contractor.
• Headwinds are a YoY drop in net income and earnings per share.
• Risks of federal budget impact to programs have been discussed.

Research Brief

Today I am covering another stock that criss-crosses the categories of innovation & managed services, part of my series of articles on large-scale federal contractors. So far, after covering L3Harris (LHX) and Booz Allen Hamilton (BAH), the next one in this series is a major player and well-known name in the national security sector in particular.

General Dynamics (GD) recently released its Q2 earnings results on July 26th, and from its most recent Q2 earnings release some key points about this firm headquartered in Reston Virginia (DC metro area) are that it took in $39B in 2022 revenue, globally has over 100K employees, and is in a diversified set of business segments including aviation, ships, combat systems, and technology solutions.

From my student days spending a leadership semester in Washington DC, to my time during a tour of duty in federal uniform, to a stint as an IT contractor for a major managed solutions provider with a tech support contract for a state government, I know firsthand the value proposal that external contractors present to the public sector decision-makers.

After all, government does not "produce" certain products & solutions it depends on, so it has to outsource that, creating a multi-billion-dollar-a-year industry in the private sector.

The question to ask, in the context of this website, is whether this sector presents an opportunity for value investors right now, and that is what I hope to determine, and more specifically does this firm stand out among peers in this sector as an investment opportunity.

Rating Method

The goal is to find value-buying opportunities in these sectors: financials, insurance, tech/innovation/managed services.

My 5-step approach is to break down the overall rating into 5 categories: dividends, valuation, share price, earnings growth, & capital strength.

If I recommend this stock in at least 3 of these categories, it gets a hold rating, and if I recommend at least 4 out of 5 then it gets a buy rating.

Dividends: Recommend

I like to start this discussion with how an investor can earn a steady income from owning shares of this stock. The analogy I use is buying an existing rental property with 20 units already paying rent each month, or quarter, rather than launching a completely new venture from scratch and throwing darts at a wall.

Much like in real estate, a savvy investor and analyst should ask what kind of yield they will get on the capital invested.

The dividend yield for this stock as of August 9th is a modest 2.35%, paying $1.32 per share with the next upcoming ex-date on Oct. 5th, according to official dividend data .

In my opinion, it is neither exceptional nor dismal, but then again a dividend yield is not the only factor we are looking at but one of them, as part of a larger holistic view of the investing potential here.

This is good news for the dividend-income investor, of which I am as well, and notable to mention is that this stock's dividend yield also is 55% above the sector average which is just a paltry 1.51%.

Unlike some financial & insurance stocks I covered lately which hover in the 5 to 8% range, stocks in this sector tend to have much more modest dividend yields in comparison. So this type of yield is already expected and not unusual.

On another positive note, I like that this stock has a positive 5-year dividend growth, going from an annual dividend of $3.63 in 2018 to $4.97 in 2022, a 37% increase over 5 years, which is impressive.

Further, this stock has a proven quarterly dividend payout since 2020 without interruption, another plus when planning quarterly income generation from this stock.

When dividend yield is considered as part of a holistic analysis, rather than just by itself, it helps build the investment idea for a stock.

At the same time, it helps to compare with other stocks of peer companies. For example, a major peer of this firm is Northrop Grumman ( NOC ), and its dividend yield right now is just 1.73%.

Valuation: Recommend

The valuation of this stock certainly gets my attention. In today's analysis, we will look at two metrics, the forward P/E ratio and the forward P/B ratio, taken from official data , as they are my two key metrics to gauge if a stock is over or undervalued compared to its sector.

In this case, its price to earnings of 17.75 is over 15% below the sector average, which is closer to 21x earnings. The sweet spot I am looking for is a valuation in line with or a few points less than the sector average, so in this case this stock has an attractive price to earnings that is not ridiculously high nor skeptically too low. Interestingly, it appears a lot of investors are willing to pay up to 21x earnings for this sector.

As far as its 3.01x price to book, it is over 16% above the sector average:

It is not great but not too bad either, and it earned a "C" grade from Seeking Alpha. Consider that a key peer, Northrop Grumman , has a 4x forward price to book which is almost 56% above the sector average.

In this case, I would recommend this stock on valuation as its P/E ratio is below the sector even though the P/B is above it, and it has a lower valuation than a key peer.

Within the context of the larger market, this stock's forward P/E of 17.75 is below that of the S&P500, discussed in a July article in Reuters that described Wall Street as currently "expensive".

According to the article:

The S&P 500 index is trading at a 12-month forward price/earnings ratio of 19.1, well above the 20-year average of 15.8, 30-year average of 16.5, and 40-year average around 16.0.

Share Price: Recommend

As of the writing of this article, I am tracking the share price around $225.44, lower than the 200-day SMA by 1.5% roughly.

I think the above share price is a buy opportunity and here my thesis as to why:

As in several prior articles I am sticking with my investment idea of tracking the 200-day SMA over a 1-year period, as a long-term trend indicator. My expectation is that this moving average will be higher in a year, so my target trading range is within 5% of this moving average. This gives me a rough framework with which to play entry/exit points. With this current 200-day average, my trading range is $217.59 - $240.50. The current share price falls within this range.

Although I recommend the current price, it is part of the holistic review of this stock and only one component of the overall rating. Note: this is not an advisement to buy or sell, so use caution & further research from multiple sources rather than just relying on this data set alone.

With that said, let's see how my thesis would play out in the following trade simulation:

In this fictitious trade, I am buying 10 shares at the current price (as of the writing of this article), holding for 1 year to earn the full year dividend income, then selling at the upper limit of my target trading range. Although I do not write about tax topics here, this scenario creates two potential tax events: qualified dividend income and capital gains. Just something to consider!

This simulation generates a 9% return on capital invested. The risk to this idea is that in a year's time the moving average is lower than expected, thereby creating unrealized capital losses. As a long-term play, however, moving averages can often return to your favor again at some point.

Earnings Growth: Not Recommended

One category I analyze is the longer-term earnings growth of a company year over year. When looking at the income statement for this firm, however, it shows a YoY drop in both net income and earnings per share which was a disappointment:

One positive notable to mention, however, since I often write about tech & innovation, is the revenue growth this company has seen in its technology solutions segment. Consider the $580MM in contracts from the intelligence & homeland security sector this company got, in addition to the millions$ in value of other programs in its pipeline:

However, I have to ding them on a YoY drop of 3% on net earnings and almost 2% drop in diluted earnings per share vs the same quarter a year prior:

All in all, though this stock will not get a recommendation today on earnings growth, it certainly has a strong revenue engine and a pipeline of programs & contracts that will keep it busy for a while!

Capital Strength: Recommend

First, let's take a look at the following two tables which give us a lot of valuable data to consider. From this data, we see that the firm has a nice positive cashflow and positive free cashflow per share, along with what I would consider good figures in the long-term solvency category:

In addition, the company reported $519MM in free cashflow for the last quarter, another positive point to mention:

On the debt side of the balance sheet, the company announced it "repaid notes of $750MM in May and $1.75B of debt in past year."

That shows a commitment to managing debt levels responsibly.

Finally, this company has a massive balance sheet, with $1.15B in cash, and also $482MM in positive equity.

This business seems to have the means to continue as a going concern for quite some time, and can be highly recommended for financial strength.

Rating: Buy

Today this stock won 4 of my 5 rating categories, earning a "buy" rating. My rating is in line with the consensus from both Wall Street and analysts, but more bullish than the Seeking Alpha quant system:

Risk to my Outlook: Politics & Competitors

As a student of leadership over the years, but also an author of a leadership & management book on productivity, I am well aware of the impact of budget cuts to programs & projects.

In the case of General Dynamics, but also its entire sector, the "upper management" to worry about are politicians that hold the purse strings of public budget appropriations. One only need to read the recent headlines in Bloomberg a few days ago talking about yet another potential budget showdown in Congress this fall.

Another analyst, Khen Elazar, highlighted this risk in his July article covering this firm and it is worth mentioning:

Client concentration is a significant risk. The company relies heavily on the U.S. government for its sales. The American government is responsible for 70% of the company's sales. Such a large portion of the sales from one client makes you vulnerable. Every future change in defense expenditures, or even stagnation, may hurt General Dynamics' growth prospects and hinder its ability to grow.

In addition, since there is one significant client, there is also harsh competition for its contracts.

However, my counter point to this risk is that even though it has dependency on federal contracts as well as stiff competition, it is also well diversified across different types of solutions so I think that could be in its favor. For example, it is not just a maker of aircraft, or technology solutions we mentioned earlier, but also has a robust marine segment as well.

While a contractor like Boeing (BA) has become synonymous with aircraft, consider that General Dynamics can set itself apart in the marine segment, as it already has a backlog and orders in the billion$, revenue growth since the prior year, and a major submarine project underway.

Getting federal contracts is also not an instantaneous process, as I learned from attending various events in Austin Texas the home of the US Army Futures Command. This company, with its many years of experience in this space, already has the know-how and processes in place to be at least among the few highly competitive bidders on those contracts.

Also, back to the marine segment, since the media gives so much attention to the latest fighter jets, let's not forget the role of seacraft for peacetime homeland security (coast guard, rescue at sea, patrols, interdictions, smuggling deterrence, surveillance, etc.). This I also highlighted to regional media in Croatia after attending the Adriatic Sea Defense & Aerospace (ASDA) Exhibition there this spring & meeting/speaking to various players in this industry but also seeing the prototypes of the latest marine vessels in the pipeline.

Hence, I think this firm is in a decent competitive position to tackle the mentioned risks.

Analysis Wrapup

Here are key points we went over today:

Positives: dividend yield vs sector average, capital strength, share price vs moving average, valuation vs sector average.

Headwinds: earnings YoY growth is down.

Concluding thoughts: I would include this company in any watchlist of large federal contractors, which is a multi-billion dollar a year industry and as long as Congress keeps appropriating the money it will keep flowing to this sector.

I expect for Q3 more of the same: meeting or beating analyst estimates, as they have done for the last four quarters. In the next one, I expect an earnings beat of around $0.07.

For further details see:

General Dynamics: Opportunity To Buy An Undervalued Major Federal Contractor With Competitive Dividend Yield