General Dynamics (GD)

Key Stats

Price/Earnings = 12.6

Price/Sales = 1.1

EV/EBIT = 12.6

Debt/Equity = 119%

Return on Equity = 27.5%

Company

General Dynamics is a 121 year old defense contractor and private jet manufacturer. They have manufactured US military staples such as the M1 Abrams tank. They are also the original designer of the iconic F-16 fighter jet.

The US government is their biggest customer and most of their business is locked-in via long term contracts.

Not only do they have ongoing contracts to build new hardware for the United States government, but they are also responsible for the ongoing maintenance of the US arsenal. That’s about as steady a stream of business as you can get in this world.

The US government is their main customer, but it’s not their only customer. 66% of revenue is derived from the US government, 9% from foreign governments (they produce the British army’s AJAX armored fighting vehicle, for instance), and 25% is from their commercial aviation business (Gulfstream jets).

The commercial aviation segment (Gulfstream aerospace – which they purchased in the late ‘90s) is the cyclical part of the business, but it is only 25% of revenue. The cyclicality of that industry isn’t something that can sink the rest of the company. If this was the sole focus of General Dynamics, this would be a terrible business to own due to its cyclicality. With that said, when times are good, it’s a fine business to own with decent profit margins (operating margins were 17.6% in 2018 and 15.6% in 2019). Another nice aspect to this business is that the contracts to build the aircraft are often locked in, so the revenue doesn’t disappear overnight during a recession.

The defense segment is split up into Combat Systems, Information Tech, Mission Systems, and Marine Systems.

Combat Systems ($7 billion in revenue) mainly consists of land-based vehicles, such as tanks. They also produce arms, such as machine guns and grenade launchers. A key vehicle produced by this division is the Stryker armored personnel carrier.

Information tech ($8.4 billion) is primarily IT work for the United States government. They provide cyber security for the Pentagon and are migrating DoD applications to the cloud. They also provide services for the US government beyond defense, such as their $2 billion contract to manage the US state department’s supply chain.

Mission Systems ($4.9 billion) are navigations and communications equipment.

The marine unit ($9.1 billion) is a critical source of growth for the company. GD is the US government’s lead contractor in the production of the Columbia class submarine, the latest generation of nuclear subs. They also manufacture destroyers, support ships, along with many other vessels. They also provide ongoing maintenance and parts for the fleet.

Valuation & Financial Quality

General Dynamics generates high returns on capital and strong margins. This is because its biggest customer is the United States government and defense contractors are essentially an oligopoly.

Returns on capital are excellent. Return on invested capital was 18.8% last year. They have maintained high returns on capital consistently for a long period of time. Returns on invested capital have averaged 17.6% for the last 20 years. To put this in perspective: Facebook has a return on invested capital of 17.7% and Google has a return on invested capital of 18.7%. Of course, GD is never going to grow as fast as Facebook or Google, but I think the comparison gives perspective into how profitable their business is.

With the exception of the decline in 2011, operating profits experienced explosive growth during the 2000’s when the Iraq and Afghanistan wars began. They have remained elevated and grown slightly even as those wars have slowed.

Even though growth in operating profits has slowed a bit, earnings per share and free cash flow per share have continued to march higher thanks to share buybacks (share count is down roughly 25% over the last decade). They also return capital to shareholders via dividends. The stock currently has a 3% dividend yield, and dividends have steadily increased throughout its history (General Dynamics is a “dividend aristocrat”). The company has a good track record of returning capital to shareholders.

General Dynamics operates with a high degree of financial quality. Debt/equity is reasonable, at 119%. The Z-Score is 2.74, showing low bankruptcy risk. The M Score is 2.5, showing no signs of earnings manipulation.

The valuation for General Dynamics is extremely cheap for a company of this quality. Currently, it trades at a 12x P/E, 12x EV/EBIT, and a price/sales multiple of 1.1.

This valuation isn’t as cheap as it was during the debt showdowns of 2011 when the P/E fell to the single digits (back when people thought the US government found spending religion – lol). It’s nowhere near as cheap as it was during the generational buying opportunity after the fall of the Berlin Wall.

Even though it’s not as cheap as it was back then, I think the stock can still deliver totally satisfactory returns from current valuations. I think that the valuation got a bit silly after Trump was elected, and has since come back down to Earth, as seen on a raw price/sales basis.

From a pure price action standpoint, sentiment is currently poor against General Dynamics. It is in a nearly 40% drawdown from its early 2018 peak.

The Moat

Defense contractors have a pretty obvious moat, which is why they all enjoy high returns on invested capital that aren’t competed away.

This isn’t an industry where they have to worry about new competitors emerging to challenge their pricing power. A startup in San Francisco called Subr isn’t going to start up tomorrow and start burning cash for 10 years provided by VC gamblers to make nuclear submarines and ruin GD’s business.

Plus, weapons manufacturing is not an industry that would attract modern ESG-minded disruption capital. That is more drawn to things like vegan hot dogs, solar powered lawn mowers, subscription services telling people how to do a push up, and putting random stuff on a blockchain.

If the US government wants high grade military equipment, then it needs to deal with the defense contractor oligopoly. Even if a big company was willing to throw $100 billion into competing in this industry, they would have a tough time. If they wanted to play in this game, they wouldn’t have the deep knowledge and defense-specific engineering skills to enter it. They would also need to build the manufacturing capability from scratch. They also would need relationships in the US government, which run deep for a company like GD.

Defense contractors like General Dynamics also enjoy extremely long term, lucrative contracts.

A good example of this is the Columbia class submarine. General Dynamics is currently locked in for production of the Columbia submarine through 2042. The Columbia nuclear subs will replace the aging fleet of Ohio class nuclear subs, which started production in the 1970’s. The government is going to spend roughly $110 billion to produce these subs, and General Dynamics has the contract. The Columbia class will start construction in 2021, and General Dynamics will be making them for 20 years. How many other businesses in the world have that kind of visibility into future revenues?

Companies like General Dynamics are also needed for ongoing maintenance and parts. Considering they have manufactured so much of the US military arsenal, that ought to produce a steady stream of business, too.

Growth Prospects

Eisenhower talked about the growing military/industrial complex back in 1960, and he was not wrong. The defense industry has been a growth sector for decades, even during the tranquil period of the 1990’s after the fall of the Soviet Union. Defense stocks tanked after the Berlin Wall fell, but the dramatic cut in defense spending that the market was worried about never really materialized. That was a generational buying opportunity which Warren Buffett bought into.

With that said, I think defense spending is likely to increase in the next 20 years beyond normal levels.

I believe that General Dynamics has a strong source of growth in a growing Naval race with the Chinese.

After the end of the Cold War with the Soviets, the United States had almost total naval dominance of the planet. The US has mostly left this naval dominance of the world on auto-pilot since the USSR collapsed.

Meanwhile, China seems determined to challenge the United States as the world’s sole superpower.

This is most evident in their efforts to build up their Naval power. They have been ramping up the size of their Navy. China currently has a 335-ship Navy (the US has 293 ships), 55% bigger than the size of their Navy in 2005. Nor is their Navy small potatoes: it includes 2 aircraft carriers and 12 nuclear attack submarines.

While the Chinese have more ships, the US leads in tonnage and global reach. That said, I don’t think there is any question that China is making a strong push to replace the United States as the world’s superpower. The US needs to deal with that and will deal with that.

The path to superpower status is the oceans.

The Russians are also expanding their navy. Putin has committed to building 51 warships and 24 submarines, including eight vessels carrying nuclear weapons.

For the first time since the 1980’s, the United States has serious Naval threats to contend with.

I don’t think the United States is going to sit idly by and allow this trend to go on forever. My guess is that the US will eventually wake up and start ramping up its Navy.

A key aspect of the US military build up will be building more ships. There are only two Naval shipbuilders in the United States right now: General Dynamics and Huntington Ingalls Industries. Both of these companies should benefit when the US begins ramping up its Navy, but I think that General Dynamics is the higher quality of the two companies. General Dynamics is more diversified beyond shipbuilding, so it should continue to do well even if my thesis about a Naval ramp up is wrong.

In a more general sense, the world is not becoming a more peaceful place. I have no idea what conflicts will emerge in the coming decades, but it seems like wishful thinking to think there won’t be any in the future. Whatever happens, it’s hard to imagine that there won’t be wars in the future and that General Dynamics won’t benefit from those wars.

Risks

I don’t believe that there is a significant risk to owning a 121 year old company whose main customer is the United States government, but let’s dive into some potential risk factors.

The main risk to General Dynamics is if the United States government curtails spending. (Please, try not to laugh.)

This happened after the budget showdown of 2011 and lasted for approximately 5 minutes and the US government returned to spending-as-normal relatively quickly once the D’s and R’s stopped posturing.

Call me skeptical, but I think that the risk of the US government finding spending religion is about the same as Charlie Sheen joining a monastery.

The defense budget could be targeted if a very left wing President won an election. The kind of person who spent a lot of time in college reading Noam Chomsky and Howard Zinn, for instance. I see this as unlikely. Joe Biden isn’t exactly Ralph Nader.

It was feared that Bill Clinton and Barack Obama would cut the defense budget, but it never happened. If Joe Biden and Kamala Harris were to win (which looks likely), I don’t think that they would cut the Pentagon, either.

It also seems like the political left is more concerned over domestic issues (like taxes, UBI, etc.) than they are about foreign affairs.

Personally, I think that there is a reason that all Doves-on-the-campaign-trail become Hawks-in-office. Once the new President sits down and sees the intelligence briefings, they quickly realize that the world is a nasty, violent, and dangerous place (probably more dangerous than the American people are led to believe) and change their tune.

The fact that the defense budget was hardly cut in the 1990’s – after the US’s main global adversary was vanquished and during the tenure of a Democratic administration – is proof that defense spending is here to stay. I think US military spending is going to grow even stronger now that China and Russia are ramping up their military and the United States will not allow itself to fall behind.

The other risk is that the United States faces some type of debt crisis where the US can no longer run massive deficits or enjoy its reserve currency status to print cash and spend recklessly. If that were to happen, the global economy will likely be a horror show, and I’d rather be invested in a company like General Dynamics instead of a company dependent upon the vagaries of the economic cycle.

The business jet segment is the part of the company that I like the least and contains the most risk, because it is cyclical, but it should perform well during economic booms and won’t eat the rest of the company during busts.

Overall

Overall, General Dynamics checks all of the key items on my checklist: (1) statistically cheap, (2) positive long-term growth prospects, (3) strong returns on capital, (4) a moat insulating it from competition and protecting those strong returns on capital, (5) financially healthy with low leverage, (6) a strong long term operating track record, (7) a track record of returning capital to shareholders via dividends and buybacks, (8) Not highly cyclical, and (9) I wouldn’t be freaked out if I wasn’t allowed to sell it for 10 years.

Random

Rest in peace, Eddie Van Halen. I loved your music and it inspired me to make many bad life decisions.

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