2023-09-13 10:02:07 ET
Summary
- General Dynamics' market-beating dividend is set to remain easily covered in 2023.
- The company reported robust revenue growth in the second quarter.
- The aerospace and defense giant maintains a vigorous financial position.
- My inputs into the discounted cash flows and dividend discount model show the stock to be trading at a 15% discount to fair value.
- The stock's 2.4% dividend yield, coupled with its 10% annual earnings growth prospects, could produce respectable returns over the medium term.
Since the dawn of mankind, humans have jockeyed for control over the planet's land and the resources that go along with it. As technology has evolved, so has how the world's hundreds of countries and territories engage in conflicts with each other.
Due to human nature, it's a certainty that conflict and power struggles will endure for as long as humanity roams the earth. As long as this is the case, it stands to reason that for better or worse, defense contractors could make interesting investments for dividend growth investors.
The aerospace and defense contractor General Dynamics (GD) is one such business that should be a stable investment in the years ahead. For the first time in over two years , let's peek at the company's fundamentals and valuation to highlight why it belongs in a dividend growth stock portfolio.
A Market-Topping Dividend That Can Fly Higher
General Dynamics has upped its quarterly dividends paid to shareholders for 26 consecutive years , which makes it a Dividend Aristocrat. And if that wasn't enough, the stock also sports a 2.4% dividend yield - - significantly above the 1.5% yield of the S&P 500 index.
Paired with the 9.2% compound annual growth rate of the dividend over the past 10 years, General Dynamics also stands out as a top-notch dividend grower. In even better news, high- single-digit annual dividend growth should continue.
General Dynamics posted $12.19 in diluted EPS in 2022. Measured up to the $4.97 in dividends per share paid during the year, this is a 40.8% diluted EPS payout ratio.
Due to the modest 4.8% dividend increase over 2022, General Dynamics is slated to pay $5.22 in dividends per share in 2023. Against the analyst consensus diluted EPS of $12.64 for the year, this would be a 41.3% diluted EPS payout ratio.
Aside from these low payout ratios, General Dynamics also has a strong growth profile going for it. Analysts anticipate that diluted EPS will grow by 10.8% annually for the next five years. This is why I believe that a 7.75% annual dividend growth rate is a fair assumption for the long run.
General Dynamics Is Displaying Its All-Around Strength
General Dynamics logged impressive topline growth for the second quarter. The company's total revenue surged 10.5% year over year to $10.2 billion during the quarter. As you can imagine, this was driven by solid performance throughout the business: Revenue grew 4.6% in the aerospace segment (third biggest segment), 7% in the technologies segment (biggest segment), 15.4% in the marine systems segment (second biggest segment), and 15.5% in the combat systems segment (fourth biggest segment).
Fortunately, General Dynamics looks like it can keep delivering admirable revenue growth to shareholders. The company's total backlog of projects edged 4.3% higher over the year-ago period to $91.4 billion in the second quarter. In other words, General Dynamics was able to secure an additional $3.7 billion in contracts with the U.S. Army, U.S. Navy, and other entities beyond the revenue that it recorded for the quarter. For context, the company's $91.4 billion backlog alone is more than enough to generate two-plus years of revenue at its current rate.
General Dynamics' diluted EPS dipped lower by 1.8% year over year to $2.72 during the second quarter. As a result of supply chain issues noted by CEO Phebe Novakovic in its earnings call , the company's operating margin contracted by 110 basis points to 9.5% in the quarter.
Because adapting to supply chain difficulties takes time to implement new and more efficient processes, this shouldn't be a surprise. Fortunately, it is anticipated that these headwinds will resolve as the year progresses. That is why the analyst consensus is that General Dynamics' diluted EPS will spike 18% higher in 2024 to $14.91.
Aside from its promising fundamentals, the company also is in fine financial shape. This is supported by an interest coverage ratio of 10.8 through the first six months of 2023. That means General Dynamics could theoretically sustain a sizable plunge in its profits and still cover its financial obligations (all details in this subhead from General Dynamics' Q2 2023 earnings press release unless otherwise noted or linked).
Risks To Consider
General Dynamics may be flourishing. However, no business is free from risk. This is precisely why stocks typically offer more attractive return profiles versus other investment vehicles.
As recently as last year, 70% of General Dynamics' revenue was derived from the U.S. government (page 15 of 127 of General Dynamics' 10-K ). As capital outlays become bigger for this customer in the years ahead, budgetary concerns could eventually lead to a downcycle within the industry. That could at least temporarily harm the company's financial results.
It's also worth noting that due to the fiercely competitive industry landscape, General Dynamics operates in a sink-or-swim environment. If the company were to fall behind on innovation, this could also hurt its operating results.
The Company Is Meaningfully Undervalued
General Dynamics is just the kind of company that you want to own in a dividend stock portfolio, but it has to be at the right valuation. In that spirit, let's use two valuation models to arrive at a fair value for the stock.
The first valuation model that I will employ to value shares of General Dynamics is the discounted cash flows model or DCF model. The DCF model has three inputs.
The first input for the DCF model is the trailing 12 months of diluted EPS, which is $12.18 for General Dynamics.
The next input in the DCF model is growth forecasts. Erring on the side of caution, I will use a 6% annual diluted EPS growth rate for the next five years. I'll then factor a deceleration to 5% for subsequent years.
The last input for the DCF model is the discount rate. This is merely the annual total return rate required from an investment. The rate that I use is 10%.
Factoring these inputs into the DCF model, I get a fair value output of $267.11. This suggests that General Dynamics' shares are trading at an 18.6% discount to fair value and can provide a 22.9% upside from the current share price of $217.42 (as of September 12, 2023).
The second valuation model that I'll use to appraise shares of General Dynamics is the dividend discount model or DDM. Like the DCF model, this also is made up of three inputs.
The first input for the DDM is the dividend per share. General Dynamics' present annualized dividend per share is $5.28.
The second input in the DDM is the cost of capital equity. I will again use 10% for this input.
The final input for the DDM is the annual dividend growth rate or DGR. I will assume 7.75% for this variable.
Plugging these inputs into the DDM, I get a fair value of $234.67. This means that General Dynamics' shares are priced at a 7.4% discount to fair value and could lead to 7.9% capital appreciation from the current share price.
Upon averaging out these fair values, I compute a fair value of $250.89 per share. That implies shares of General Dynamics are trading at a 13.3% discount to fair value and offer a 15.4% upside from the current share price.
Summary: General Dynamics Is A Dividend Stock You Can Trust
For as long as I have lived, General Dynamics has paid out more cash to shareholders than it did in the year prior. And there is arguably no end in sight to this trend. That is because the company is a leader within the aerospace and defense contractor industries. Not to mention that its diluted EPS payout ratio leaves an adequate cushion if the industry ever experiences a downturn.
Throw in the fact that shares of General Dynamics look undervalued by a double-digit percentage and you have the makings of an attractive dividend stock.
For further details see:
General Dynamics: A Dividend Aristocrat That Can Help Your Dividends Take Flight