General Dynamics Stock: Bet On Rising Geopolitical Volatility (NYSE:GD)

Thesis

Geopolitical volatility has been on the rise. The enterprises that thrive in such an environment are the shipping, energy, and defense industries. I have discussed shipping extensively in my articles. Now, it is time to venture into my two favorite industries: energy and defense. Today’s article discusses General Dynamics (NYSE:GD), one of the major defense contractors in the US.

GD is one of two enterprises building nuclear-powered submarines for the US Navy (the other being Huntington Ingalls (HII)). It also operates in the aerospace, combat systems, and technologies segments. The eponymous business jet manufacturer Gulfstream is also part of GD’s portfolio.

The defense business is one of the toughest. It is hated, extremely regulated, and depends on one customer: the government. Moreover, it requires highly skilled labor, and will cease to exist sooner rather than later without considerable R&D expenditures.

GD, Lockheed Martin (LMT), and Northrop Grumman (NOC) are the big three in the US defense industry. GD is one of my favorite companies in the defense industry due to its excellent balance sheet, well-diversified portfolio of operations, and secure dividends. Today, I will analyze the results of GD 2023, review the geopolitical situation, and discuss GD’s valuation.

Geopolitical volatility and defense budgets

The world is moving from unipolar to multipolar, translating into a growing number of conflicts and increased defense spending. US defense spending as a percentage of GDP has bottomed below 5%.

For comparison, that ratio was above 10% during the Cold War. The following chart from the World Bank paints a similar picture of the World’s defense budget compared to GDP.

The number of proxy conflicts has grown significantly over the past few years. I believe this is the new normal where the Great Powers project their power into third countries and use them as a theatre of war. Simply put, I expect the defense budgets to double from here until the end of the decade. That means the defense companies will turn into cash machines.

Operations

GD has four operating divisions: Aerospace Systems, Combat Systems, Marine Systems, and Technology. For two consecutive years, the Tech division brought in more than a third of the company’s revenue, closely followed by the Marine segment. Aerospace and Combat Systems delivered approximately 20% of the annual revenue each.

GD Aerospace segment builds Gulfstream jets, which were acquired in 1999. Gulfstream added diversification to the company’s customer base. The business jet industry heavily benefits from rising geopolitical volatility, too. Unlike the defense industry, it has private customers, diversifying the company’s sources of income.

GD marine subsidiary, Electric Boat builds Ohio-class nuclear submarines. In 2020, Electric Boat started building Colombia-class submarines, Ohio’s successor. The goal is to build 12 Colombia submarines. The company’s land systems build the M1 Abrams tanks, the US Army’s main battle tank. Armies across the globe widely adopt M1: Australia, Saudi Arabia, and Poland are a few examples.

In 2023, GD’s operations faced two obstacles: labor shortages and supply chain disruptions. The company mitigated its negative impact to a certain degree. In its last earnings call, GD’s CEO, Phebe Novakovic, discussed the topic. She mentioned an improvement across company divisions and emphasized that GD developed an employee training program.

The supply chain issue is still persistent, though its impacts are decreasing. The Aerospace division remains the most affected. Gulfstream G280 is built in a facility close to Tel Aviv. GD expects delays in G280 deliveries, resulting in fewer jets being delivered. Nevertheless, GD reported a strong delivery number for 4Q23, 39 airplanes, compared to 24 in 3Q23 and 25 in 2Q23.

The table below from the GD 2023 report shows Gulfstream deliveries annually and quarterly.

In 2023, the GD aerospace division had a 13.7% operating margin, 50 bps higher than the FY22 figure. Orders reached $10 billion for the third consecutive year, resulting in a 1.2 book-to-bill ratio. GD aircraft services generated 8% YoY revenue growth. The Aerospace division ended 2023 with a $20.5 billion backlog.

The highlight of the last month is the long-anticipated certification of Gulfstream G700. On March 29, 2024, the company announced that G700 had received FAA (Federal Aviation Administration) type certification.

In 2023, the GD Combat Systems division delivered $8.26 billion in revenue, 12% higher than in 2022. The backlog in 4Q23 was $14.5 billion, and the to-bill ratio was 1.1. In 4Q23, Combat Systems entered a few contracts: $230 million for maintenance and modernization of Leopard fleet of vehicles for Spain; $200 million contract to upgrade M1 Abrams tanks; $100 million contract for Piranha armored vehicles with Switzerland army. In February, GD announced that Steyr awarded a $1.3 billion contract to build 225 Pandur armored vehicles for the Austrian Army.

Marine Systems scored record revenue YoY growth, reaching $12.4 billion in 2023. The primary driver is the Colombia class program. The marine division reported a $45.9 billion backlog in 4Q23 or 49% of the company’s total. GD received an award of $840 million for maintaining and upgrading two DDG-51 guided missile destroyers.

In 2023, the Tech division delivered $12.9 billion in revenue, 3.6% higher than in 2022. At the end of 2023, the backlog was $12.7 billion, and the book-to-bill ratio was 1.0. GD signed a contract with Indian Health Services for an electronic health records system of up to $2.5 billion. GD reported a $975 million contract with the US Army to provide mission command training.

Financials

2023 ended up with a record-high backlog of $93.6 billion and book to bill 1.1. In 2023, GD delivered $42.2 billion in revenue and $4.25 billion in operating earnings. In comparison, in 2022, GD realized $39.4 billion in revenue and $4.2 billion in operating earnings. The best-performing divisions YoY are Marine Systems and Combat Systems, which delivered 12.9% and 13.1% revenue increases, respectively. Looking at the operating margins, the picture is different.

Only the Aerospace division reported higher YoY margins, from 13.2% in 2022 to 13.7% in 2023. The other three divisions delivered lower margins compared to 2022. In 2023, GD realized $3.3 billion in net earnings and $12.02 EPS (diluted).

In 2023, GD delivered $4.7 billion operating cash flow, $107 million higher than in 2022. The company realized $2.37 billion unlevered FCF vs. $2.53 billion in 2022. The following graphs compare GD, NOC, HII, and LMT FCF yield and FCF per share.

GD lags behind its peers, though it still delivers an adequate FCF yield of 4.3%. The FCF has been relatively stable, moving in the 4-8% range over the last three years, though I expect more robust performance in 2024.

The following table shows 2024 projections.

Profit margins are expected to grow across the segments, leading to $14.35-$14.45 EPS or 20% YoY growth in EPS. Given the rising uncertainty in the Middle East and Ukraine, the global defense budget will continue to move upward. The US, in particular, is funding military operations in Ukraine and Israel. Besides that, the US approves a military aid program for Taiwan. In conclusion, I expect that GD will deliver its promises.

Dividends

GD pays dividends with a mediocre yield compared to shipping companies. However, the company shines in other aspects – dividend consistency and safety.

GD’s dividend yield is comparable with that of its peers, at about 2%. Only LMT approaches 2.8% FWD yield. GD’s payout ratio is 43.9%, similar to LMT, though higher than NOC (31.5%) and HII (29.3%).

Balance sheet

On December 31, 2023, GD reported $1,913 million cash, $8,754 million long-term debt, and $11,083 million total debt (including $1,497 million lease agreements). FY23 GD delivered $4,706 million operating cash flow and incurred $343 million net interest expenses. GD keeps a superior balance sheet among the big three defense contractors (NOC, LMT, GD).

The company has 52% total debt to equity, the lowest in the group. Its direct competitor, Marine Systems HII, has similar liquidity and solvency metrics.

Valuation

GD share gained 12% YTD and 29.7% on an annual basis. Is it still a bargain?

At first glance, LMT is expensive. It trades in the higher percentile compared to its 10Y averages, US and Canada Industrials and Global Equities. However, compared to its peers, GD comes at a reasonable price.

GD trades at 2.08 TTM EV/Sales and 19.26 TTM EV/EBITDA. HII score lower multiples, 1.15 and 11.81, respectively. Looking at TTM vs FWD multiples reveals that GD is not that expensive. GD trades at 19.26 TTM EV/EBITDA vs 14.7 FWD EV/EBITDA. Considering the projections for YoY EPS growth of 20%, this figure seems plausible. In conclusion, GD is not cheap. It’s reasonably valued with adequate upside potential versus relatively low downside risk.

Investors Takeaway

GD operates in the industry that benefits the most from rising global uncertainty. The company is one of two defense contractors building nuclear submarines, manufactures Gulfstream business jets, and has a thriving Tech division. What is not to like about it?

As with every thesis, GD comes with risks, too. Let’s start with the idiosyncratic risks. The company is financially sound, judging by its capital structure and liquidity metrics. As a defense contractor, GD has a considerable moat. So, new competitors cannot arise out of the blue and claim GD’s positions. Building a business in the defense industry requires highly trained personnel, takes time, needs tons of capital, and has to overcome endless legal hurdles.

The defense industry is recession-proof and relatively indifferent to stock market moves. The 24M Beta is 0.68. GD. For comparison, TSLA has 2.44 24M beta, and AAPL has 1.28. Of course, in case of a massive market crash, GD stock’s shares will tank, too.

Last summer, I started to build a position at GD, using the pullbacks to add along the way. I expect the stock price to surpass the $300/share threshold in the coming quarters, so I give GD a buy rating.