General Dynamics: Strong Industry Tailwinds, but Fully Priced

General Dynamics (GD) is an international aerospace and defense company that focuses on high-end design, engineering, and manufacturing state-of-the-art solutions for its global customers.

The company’s broad portfolio of products and services comprises business aviation, shipbuilding, land combat vehicles, weapons systems, munitions, as well as technology services.

What differentiates General Dynamic compared to its industry peers is that each of its business units is responsible for optimizing its own operating results. Hence, the company operates with less friction and significant flexibility when it comes to each segment’s CAPEX requirements and overall capital allocation needs.

Over the past couple of decades, General Dynamics has managed to produce outstanding value creation for its shareholders. Specifically, the company has not only consistently generated predictable revenues and net income, but it features a fantastic track record of tangible capital returns (dividends, share buybacks).

Following Russia’s invasion of Ukraine, governments around the world have been expanding their defense budgets. Consequently, the stock should be enjoying robust tailwinds in the medium term, which is the reason shares have been now approaching new all-time highs.

However, due to the stock’s valuation hovering at rather elevated levels, I am neutral on the stock.

Latest Results

General Dynamics’ latest results once again demonstrated the company’s ability to successfully deliver its order backlog and produce resilient financials.

Quarterly revenues declined 1.8% to $10.3 billion, while earnings per share fell 2.9% to $3.39 compared to last year. However, the slight decline in the top and bottom line hardly matters compared to how we assess most other companies.

We mostly care about General Dynamics’ ability to grow its backlog and its general capability to deliver on it. As long as the backlog grows, the company’s top and bottom lines should gradually do as well, as has been the case historically.

Fortunately, General Dynamics’ new order traction remains very strong, with the company featuring a book-to-bill ratio of around 1.7x. In other words, General Dynamics’ revenues over the next 1.5 to 2.0 years are secured by its customers as long as the company, of course, delivers on this backlog.

In any case, the company’s backlog growth usually precedes its delivery volumes. Thus, the company has been able to retain a healthy book-to-bill ratio, which ensures it enjoys predictable and secure cash flows.

In response to the ongoing situation in Ukraine, Western governments are now increasing their defense budgets as they strengthen their militaries and replenish the equipment they have been sending to aid Ukraine. Hence, General Dynamics’ book-to-bill ratio should further improve going forward.

Capital Returns & Valuation

Amid stable and predictable cash flow generation, General Dynamics has been able to grow its capital returns significantly over time. Specifically, the company features a robust dividend growth track record, numbering 31 years of consecutive annual dividend hikes.

This means the company is one of the elite constituents of the S&P 500’s Dividend Aristocrat Index. The company features a 10-year dividend growth CAGR of 9.82%, which is rather impressive considering how mature its dividend track record is. The latest dividend hike was also quite solid, boosting its quarterly rate by 5.9% to $1.26.

General Dynamics has also been repurchasing heavy amounts of its own stock over the years, which has led to a significant reduction in the share count, thus boosting EPS growth over time. Specifically, the company has bought back and retired around 31.5% of its common stock since 2007, which is utterly remarkable.

Management forecasts revenues to land between $39.2 billion and $39.45 billion and EPS to come out between $12 and $12.15 for fiscal 2022. The midpoint of management’s guidance implies that the stock is currently trading at a forward P/E of 19.9 at its current price levels.

On the one hand, this sounds like quite an attractive valuation considering the macro outlook for defense stocks appears very favorable. On the other, the current multiple is near the highest point of the stock’s historical forward P/E range.

The market likely expects above-average EPS growth in the coming years. However, as we noted earlier, General Dynamics’ results are a function of its backlog and the company’s ability to deliver on it. Even if the backlog grows going forward, which is definitely positive news, the company’s production capabilities should only expand lightly each and every year.

Hence, this does not necessarily translate to a sudden jump in the company’s earnings going forward. Consequently, I would consider shares more reasonably valued close to a forward P/E of 17.

At this point, the stock is valued at a premium relative to its historical multiples that reflects the tailwinds it is about to enjoy, without investors notably overpaying for the increased security attached to the forthcoming backlog growth.

Wall Street’s Take

Turning to Wall Street, General Dynamics has a Moderate Buy consensus rating, based on seven Buys and three Holds assigned in the past three months.

At $264, the average General Dynamics stock projection implies 9.9% upside potential.

Conclusion

General Dynamics has proven itself as one of the most resilient companies in the aerospace and defense sector, able to produce predictable cash flows for decades.

The company’s bill-to-backlog ratio remains very healthy, which should indicate that this resilience should last. In fact, with governments all over the world increasing their defense budgets, the ratio is pretty much guaranteed to remain very healthy in the medium term.

While General Dynamics’ features multiple other qualities, including one of the most impressive capital return track records in the space, it appears that the recent rally has likely overpriced the stock.

Could General Dynamics still be a great long-term investment with robust dividend growth potential? Certainly. At its current price though, the stock should not yield extraordinary total returns.

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