Updated on February 14th, 2019 by Josh Arnold
The Dividend Aristocrats are a group of 57 companies in the S&P 500 Index, with 25+ consecutive years of dividend increases.
We review all 57 Dividend Aristocrats each year. The next stock in the series is aerospace and defense company General Dynamics (GD).
General Dynamics is one of the newer members of the Dividend Aristocrats, having joined the list in 2017.
Defense stocks took flight from 2014-2018, but General Dynamics’ once-outstanding share price growth stalled out last year. General Dynamics stock has declined over 20% in the past one year, which has brought its valuation back in line with expectations.
General Dynamics is an attractive holding for dividend growth investors, and is close to being attractive on a valuation basis as well.
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. General Dynamics currently generates annual sales nearing $40 billion.
The company’s revenue stream has been diversified in recent years, and it now no longer relies as much upon the Aerospace segment as it used to.
A breakdown of its segments and their contribution to revenue is below:
- Aerospace (25% of revenue)
- Combat Systems (17% of revenue)
- Information Technology (22% of revenue)
- Mission Systems (13% of revenue)
- Marine Systems (23% of revenue)
These segments all have varying growth outlooks and margin profiles but together, they create a diversified, very profitable stream of revenue for General Dynamics.
The company’s Aerospace segment produces aircraft and services them for its customers. It was recently expanded with the acquisition of Hawker Pacific.
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. Mission Systems provides services to the armed forces such as product line management for training.
Lastly, the Marine Systems group builds nuclear-powered submarines and surface combatants for the U.S. Navy, and also Jones Act vessels.
General Dynamics has produced strong earnings growth in recent years, and the trend should continue moving forward, although 2019 is slated to produce a modest increase over 2018.
General Dynamics reported fourth-quarter and full-year earnings in late January (1/30/19), and growth was strong. The Aerospace segment saw its 2018 revenue rise 4% and its operating earnings decrease 5.5%. Combat Systems posted a 4.9% gain in revenue and a 2.7% increase in operating earnings.
Information Technology saw its revenue soar 87.5% and its operating earnings gain 63% for the year thanks mostly to the CSRA Acquisition. Meanwhile, Mission Systems saw its revenue rise 5.5% and its operating earnings increase 3.3% during the year.
In all, General Dynamics’ defense-related businesses performed well in 2018.
Source: Earnings Presentation
Finally, Marine Systems posted a 6.2% revenue increase and an 11.1% gain in operating earnings, as it was the only reporting segment to boost its operating margins during 2018.
In total, earnings-per-share increased 15% during 2018 thanks primarily to the CSRA acquisition and a lower share count. General Dynamics’ average growth rate in the past decade is about 7%, so 2018 came in at roughly double its normal rate of growth.
Moving forward, General Dynamics will continue to benefit from growth in defense spending, both in the U.S. and the international markets.
President Trump has advocated for higher levels of defense spending in the U.S., which has been and will continue to 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. General Dynamics and its competitors will be the beneficiaries of this risk.
In 2018, General Dynamics generated $2.5 billion in free cash flow and returned $1.8 billion to shareholders via buybacks, while sending another $1 billion via dividends. It boosted the dividend 11% in 2018, marking its 27th consecutive annual dividend increase.
The company believes it will see $11.65 in earnings-per-share this year, representing just 2% growth over 2018.
Source: Earnings Presentation
General Dynamics has had years of slow or even negative growth in the recent past, so it isn’t particularly unusual in what is a very cyclical business.
Management sees ~6% revenue growth as the key driver of earnings in 2019, offset partially by lower margins. In particular, Aerospace margins are set to move materially lower again in 2019, while Marine Systems margins should moderate slightly. We do not believe the growth story for General Dynamics is dead by any means, but 2019 looks to be a year of transition rather than progress.
Competitive Advantages & Recession Performance
General Dynamics has several competitive advantages. First, it operates in defense, which has very 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, that totals in the hundreds of millions of dollars annually. Indeed, this is part of the significant barriers to entry for potential 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. This will drive ever-increasing levels of defense spending, the US included.
And, General Dynamics’ revenue is secured by long-term contracts with its customers, and switching costs are very high, sometimes impossibly so. This also keeps earnings intact during recessions.
Valuation & Expected Returns
General Dynamics stock has a price-to-earnings ratio of 14.8 today, which is well off of its former highs in 2017 in excess of 20. It is also much more in line with the company’s historical multiple, which has tended to be around 14 times earnings.
Thus, at its current valuation, General Dynamics is trading only slightly in excess of fair value, making the stock much more attractive than it has been in recent times.
Given the stock’s historical multiples as well as the company’s forecast slowdown in growth, we see 14 times earnings as fair value.
Using a fair price-to-earnings ratio of 14, and the company’s expected 2019 adjusted earnings of $11.65, yields a fair value estimate of $163. With the share price at $173, it is trading slightly in excess of fair value.
Given all of these factors, we see total annual returns of about 9% in the coming years, consisting of the current 2% yield, 8% earnings growth, and a very small headwind from the declining valuation. General Dynamics is nowhere near as expensive as it once was, and we therefore rate the stock a hold.
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.
While the valuation has certainly improved, the stock is still trading slightly above fair value. Combined with the expected growth slowdown in 2019, we view General Dynamics as a strong holding for dividend growth but believe investors should wait for a better opportunity before initiating a position.