‘Dividend Aristocrat’ General Dynamics Has Big Risks in 2018

Investors may want to hold off on buying currently-overvalued GD stock.

By Sure Dividend

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General Dynamics Corporation (NYSE:GD) is a one of The Dividend Aristocrats, a group of 51 companies in the S&P 500 Index, with 25+ consecutive years of dividend increases. Aerospace and defense company General Dynamics is the newest member of the Dividend Aristocrats, having joined the list in 2017.

Not only has the company increased its dividend for 25 consecutive years, but the stock has rewarded investors with huge share price gains. General Dynamics stock has tripled in the past five years.

General Dynamics stock has potential for 10% annual dividend growth. However, the valuation of GD could be a risk factor moving forward.

Business Overview For GD Stock

General Dynamics currently generates annual sales above $30 billion. It has a large aerospace segment which is the core of the business.

General Dynamics was incorporated in 1952, through the combination of the Electric Boat Company, Canadair, and several others.

The company has evolved over the years, to enter new businesses of the future. The biggest transformation came in the 1990’s, when General Dynamics started buying technology-oriented companies.

For example, General Dynamics acquired Defense Systems from the Lockheed Martin Corporation (NYSE:LMT), Advanced Technology Systems, and Computing Devices International. In 1999, it acquired GTE Government Systems.

All these acquisitions established the foundation of the company’s Information Systems and Technology group.

Today, General Dynamics has a diversified business model. Its most profitable segment is Aerospace, which primarily manufactures business jets, under the Gulfstream brand.

Source: 2016 Annual Report, page 2

Its products and services include aviation, combat vehicles, weapons systems, and munitions.

Other reporting segments include Combat Systems, Information Systems & Technology and Marine Systems.

The Combat Systems business manufactures combat vehicles, and related weapons systems and munitions.

The Information Systems and Technology business sells technologies to the military and for civilian, state and commercial purposes.

Lastly, the Marine Systems group builds nuclear-powered submarines and surface combatants for the U.S. Navy, and also Jones Act vessels.

Growth Prospects for General Dynamics

General Dynamics stock has produced strong earnings growth in recent years, and the trend should continue moving forward.

Total revenue declined 0.4% in 2016, due to the strong U.S. dollar, which negatively impacted the company’s international business. In addition, aerospace revenue declined 5% because of falling Gulfstream jet orders.

Fortunately, growth in other businesses helped offset these declines.

For example, revenue increased 2% in the Information Systems & Technology and Marine Systems segments.

And, General Dynamics cut costs to boost margins. Operating margin of 13.7% in 2016 was up 40 basis points from the previous year.

Overall, General Dynamics stock’s earnings-per-share increased 8.7% in 2016. The company generated a strong 18% return on invested capital. Operating earnings, ROIC, and dividends have all increased steadily in the past few years.

Source: 2016 Annual Report, page 10

General Dynamics is off to a good start in 2017. Earnings-per-share from continuing operations increased 6.8% over the first three quarters, driven by operating profit growth of 13% and 11% in combat systems and aerospace, respectively.

Moving forward, General Dynamics will benefit from growth in defense spending, both in the U.S. and the international markets.

Furthermore, President Trump has advocated for higher levels of defense spending in the U.S., which would be a tailwind for General Dynamics.

In addition, international markets are likely to continue raising defense spending as well. Geopolitical risk remains elevated across many parts of the world.

Demand for General Dynamics’ products and services remains strong, evidenced by a total project backlog of $63.9 billion last quarter, which was up 9% from the previous quarter.

Competitive Advantages & Recession Performance

General Dynamics has several competitive advantages. First, it operates in defense, which has high barriers to entry. Defense companies rely on contracts from the U.S. and foreign governments. A small competitor would have difficulty entering the defense industry and trying to take share.

In addition, General Dynamics has industry-leading brands, such as Gulfstream and Stryker. It has built these brands with significant research and development spending:

  • 2014 research-and-development expense of $358 million
  • 2015 research-and-development expense of $395 million
  • 2016 research-and-development expense of $418 million

This R&D helps the company secure its position among its competitors.

General Dynamics is built to last. The company performed very well during the last recession:

  • 2007 earnings-per-share of $5.10
  • 2008 earnings-per-share of $6.13 (20% increase)
  • 2009 earnings-per-share of $6.20 (1.1% increase)
  • 2010 earnings-per-share of $6.82 (10% increase)

As you can see, the company grew earnings in each year of the recession, including two years of double-digit growth. It would not be easy to find many companies that grew earnings-per-share by 20% in 2008, but General Dynamics did it.

One major reason for the company’s excellent recession performance, is because it sees steady demand for its products and services each year. The world has many dangerous places. Global conflicts are not likely to cease any time soon, regardless of the economic climate.

And, General Dynamics’ revenue is secured by long-term contracts with its customers. This also keeps earnings intact during recessions.

Valuation & Expected Returns

General Dynamics stock has a price-to-earnings ratio of 20.2. This is significantly above its 10-year average price-to-earnings ratio of 12.5.

Source: Value Line

At its current price-to-earnings ratio, General Dynamics is trading at a roughly 62% premium to its 10-year average. As a result, if the stock were to revert to its average valuation, it would cause a significant loss.

We believe fair value for General Dynamics to be a price-to-earnings ratio of approximately 17-18. This is closer to the average valuation in the years since the Great Recession, which includes a more normal economic environment.

Using a fair price-to-earnings ratio of 17-18, and the company’s expected 2017 adjusted earnings of $9.70, yields a fair value estimate of $165 to $175.

Aside from changes in the valuation multiple, future returns will be comprised of earnings growth and dividends. In the past 10 years, the company increased earnings-per-share by approximately 7% per year. This seems to be a reasonable set of expectations for future growth.

As a result, potential returns could be as follows:

  • 3%-4% revenue growth
  • 5% margin expansion
  • 2%-3% share repurchases
  • 6% dividend yield

In this forecast, total returns would reach approximately 7%-9% per year, including dividends. However, a contracting price-to-earnings ratio would reduce total returns.

Final Thoughts on General Dynamics Stock

General Dynamics is a high-quality business, with a long history of growth. Geopolitical risk remains a constant, which gives the company a long runway of growth going forward.

General Dynamics is a shareholder-friendly company, and should continue returning significant cash to shareholders through buybacks and dividends.

At this time, General Dynamics appears overvalued. It may be sensible for investors to wait for the price-to-earnings ratio to decline into the teens, with a 2% dividend yield or higher before buying.

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