Our rating on General Dynamics Corp. (NYSE: GD) is HOLD. We are once again cautious on the stock due to problems in the Aerospace segment, this time related to the impact of the coronavirus on deliveries and orders. Over the long term, GD management is focused on driving growth through modest sales increases, margin improvement, and share buybacks. The company also aggressively returns cash to shareholders through increased dividends.
The beta on GD is 1.01.
General Dynamics posted 3Q EPS that fell 8% year-over-over but topped consensus expectations.
For example, travel restrictions due to the pandemic have delayed deliveries of business jets, particularly overseas. In the Information Technology sector, GD has had reduced access to customer sites and thus lower billings. At the same time, the Department of Defense is accelerating payments to defense contractors to support the defense industrial base. The combined impact of the factors, according to management, has reduced EPS by $1.83 through nine months.
Management revised its 2020 guidance on the 2Q conference call. It now expects EPS of $11.00-$11.10. On the call, CEO Phebe Novakovic commented that 2Q would mark ‘the low point of the year.’
EARNINGS & GROWTH ANALYSIS
GD has five primary business segments: Aerospace (21% of 3Q revenue), which includes the Gulfstream jet business; Combat Systems (19%), which builds tanks and other land combat equipment; Marine Systems (26%), which builds nuclear-powered submarines and combat-logistics ships and Mission Systems (13%), which provides communications and surveillance services.
Revenue performance was mixed in 3Q. Marine Systems (+8%) and Combat Systems (+4%) grew, while the other segments were flat (Mission Systems) or saw lower revenue (Aerospace and IT). Management noted that Information Technology revenues have fallen because certain classified clients are allowing only their own employees to work at their facilities.
The Aerospace segment, which includes Gulfstream business jets, is the one that analysts have been watching closely. Over the past two years, Gulfstream has been transitioning to new aircraft (from the G450 to the G550, the G650 and soon the G750), and, after a manufacturing problem with a supplier, demand was finally starting to build in 4Q19. Then the pandemic struck. The company delivered only 32 aircraft in both 2Q and 3Q. Orders are picking up a bit, though. Management noted that closing Gulfstream deals is ‘difficult’ in this environment. The book-to-bill ratio for Gulfstream rose to 0.9 in 3Q20 from 0.5 in 2Q20 and 1.1 in 1Q20. Management in the 3Q call cautioned that deliveries may fall slightly next year.
Marine Systems is the segment with the largest backlog, including contracts for the Virginia-class attack submarine and the future Columbia-class ballistic-missile submarine.
On the expense side, the pro forma operating margin was 11.5%. Information Technology was the only segment with improved margins in 3Q.
FINANCIAL STRENGTH & DIVIDEND
Operating earnings covered interest expenses by a factor of 12 last year. In 3Q, the cash conversion ratio was a healthy 108%, indicating high-quality earnings.
GD also uses excess cash to buy back stock.
MANAGEMENT & RISKS
Phebe Novakovic has been the Chairman and CEO of General Dynamics since 2013. Ms. Novakovic was formerly the COO. She has also held management roles in GD’s Marine Services business and in the planning and development division. Jason Aiken is the CFO.
The company has set goals and provided an outlook for 2016-2020 (pre-pandemic). It expects compound annual sales growth of 5.6%.
GD mitigates risks related to U.S.-government spending through its strong position in the business jet space and its solid international business, which accounts for about 20% of revenue. That said, the business jet market is affected by global economic and stock market trends, which are outside of management’s control.
General Dynamics is a defense contractor with leading market positions in business aviation and aircraft services, land and amphibious combat systems, mission-critical information systems and technologies, and shipbuilding and marine systems. The company is headquartered in Falls Church, Virginia.
We may look to get this well-managed company back on the BUY list if the shares fall back toward $120.