GD - General Dynamics: Rise In Global Military Spending Could Drive Outperformance

2023-04-07 04:56:44 ET

Summary

• Despite the past few years of underperformance, General Dynamics is ready to get back on track.
• GD stock will benefit from the global increase in military spending.
• General Dynamics is insurance in case of increasing geopolitical tensions.
• The stock is currently undervalued, so a great buying opportunity.

General Dynamics ( GD ) is a great opportunity in the current macroeconomic and geopolitical context. Despite not having shown brilliant performance in recent years, the company is poised to capitalize on the increase in global defense spending because of its strategic positioning and its almost irreplaceable defense technology and products. Moreover, the undervaluation of the company relative to its fair value makes it an excellent pick for both long-term and medium-term investment.

Some numbers about the company

General Dynamics , one of the world's largest defense companies, plays a strategic role in supplying military technology and equipment to the United States Armed Forces and its allies in the NATO area. Last year, the company's defense business generated $25.9 billion in revenue, making it the fifth-largest defense player in the world. Its portfolio includes critical defense products such as Virginia-class attack submarines, Columbia-class ballistic missile submarines, and Abrams tanks, making the company essential for the US defense system.

General Dynamics' importance and strategic value are also highlighted by its strong performance in 2022 during the outbreak of war in Ukraine. The company's order activity and backlog were robust, with a total backlog of $91.1 billion and a total contract value of $128 billion. According to the latest annual report, the aerospace segment is the best-performing segment, with sales, earnings, margin, and order backlog increasing, with a book-to-bill ratio of 1.5-to-1 and orders of $12.6 billion.

Overall, revenues in FY22 increased by 2.4% to $39.4 billion, while net profits increased by 4.1% to $3.4 billion, with a constant gross margin despite some supply chain problems.

Furthermore, General Dynamics' financial position is very solid. Looking at the main ratios, we see a current ratio and quick ratio of 1.37x and 0.85x, respectively, both of which are better than the historical average. Additionally, the debt/equity ratio shows a positive trend starting from 2018, where it decreased from 105.8% to 65.2% this year. In fact, in Q4 2022, the company's strong free cash flow allowed it to reduce debt by an additional $1 billion, demonstrating the effective management of the company on the issue.

Finally, it's worth mentioning the dividend, which currently has a yield of 2.20%, well above the SP500 average, while the payout ratio is healthy and stable at 31.01%. The good news is that the dividend will be raised from the current $5.04 to $5.28, with a forward annual dividend yield of 2.27%.

Therefore, General Dynamics is not only extremely strong financially, but it's also very interesting thanks to the backlog activity and the dividend, which has been on a steady upward trend since 2006.

The Defense Sector is poised to grow

In general, my view on the defense sector has always been very bullish in recent months. It's not new that in all my articles on companies in the sector, I mention this very often. However, here I will summarize to be brief, but I'll leave some of my articles where I talk about the subject in more detail, which perhaps could be of interest to the reader.

In summary, most of the countries in the NATO area have announced an increase in defense spending up to 2.0% of the country's GDP. However, in other European countries, such as Poland or the Baltic area countries, spending could exceed this level with a 3% target, and this certainly represents a good opportunity for General Dynamics, especially in terms of its ground equipment and vehicles.

Another scenario that could push orders higher concerns tensions between China and Taiwan. The latter needs not only the missile systems and aircrafts of Raytheon (NYSE: RTX ) and Lockheed Martin (NYSE: LMT ), but also the know-how of General Dynamics regarding IT support services and its combat vehicles. Furthermore, General Dynamics submarine and naval equipment would be in high demand to strengthen the US Navy's Pacific fleet in the event of further tensions.

Therefore, the defense sector is not only interesting for important future growth but also an excellent insurance in case of geopolitical tensions increasing both on the Ukrainian front and in the case of a cooling of relations between the US and China.

General Dynamics' Performance

Looking at General Dynamics' performance in the last 5 years, it is evident that the company has not performed very well. While the SPX made a return of +56.96%, GD only returned +5.21%, compared to +15.95% by iShares U.S. Aerospace & Defense ETF (BATS: ITA ), the ETF that tracks the performance of the defensive sector. Moreover, GD's peers, such as Lockheed Martin and Raytheon, have performed better with returns of +46.42% and +35.67%, respectively.

Even in the last year, despite the excellent returns of the sector, GD has not performed very well. While ITA returned +4.03%, GD returned only -5.73%. However, GD outperformed SPX, which was -8.76%.

The company's last few years financial results explain its underperformance. In fact, although revenue has increased modestly, net income has remained almost flat. This is in contrast to LMT and RTX, and other companies in the sector, which have performed better in terms of growth, both in net income and revenue. Indeed, GD is a stable company both from a business and financial perspective, but it may not achieve very high growth. Indeed, analysts expect an average annual growth rate of between 4.5% and 5.0% over the next 5 years, which is less compared to the expected growth of the overall sector. On the other hand, General Dynamics is less volatile and historically has held up relatively well in strong drawdowns.

Finally, it is worth noting that GD is closely correlated with the defensive sector, despite its modest performance. Therefore, as I expect the defense sector to be very bullish in the next 5 to 10 years, I think GD is likely to follow this upward trend.

Valuation

To evaluate General Dynamics, I used a Discounted Cash Flow Model based on the company's last 10 years of financial results. Below, I have attached all the final tables with my assumptions.

In particular, I have assumed a terminal growth rate of 3.50%, modeling it on spending that I expect to be in line with or slightly higher than US GDP growth. For practicality, I have set the growth of the FCF at 3.50% from 2028, although the model gave me a slightly lower growth rate due to revenue, with an average of around 3.40% from 2028 to 2031. While this did not heavily influence the final result of the model, I wanted to point it out.

The model's output provided me with a WACC of 9.46%. After discounting the FCF projection, I arrived at a fair value of the company of $255.37. This means that General Dynamics has a potential upside of +12.32% from its current price of $227.35.

Bottom Line

In conclusion, General Dynamics operates in an industry that is expected to remain highly attractive for the next few years, and despite its current undervaluation, the company possesses significant potential for growth and overperform the market. Hence, with a potential upside of over 12%, I strongly recommend a "Buy" rating for this stock.

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