Dividend Aristocrat and aerospace giant General Dynamics (NYSE:GD) just reported earnings its Q3 results. We had been particularly excited about the recent report, expecting another quarter of solid profitability backed by the sector’s robust cash flows, which would hopefully lift shares from their recent lows.

Despite COVID-19-related disruptions in its supply chain, the company managed to deliver stable financials. Still, the Street seems to lack any excitement, as the stock closed 1.8% on the very same day. In our view, General Dynamics remains mispriced, offering a great total return potential, while the stock’s humble valuation also ensures a sound margin of safety. Let’s break this down.

In this analysis, we will:

  • Go over the recent quarter’s financial highlights.
  • Assess the stock’s capital returns, valuation, and expected investor returns.
  • Conclude why shares remain attractively priced, with the potential to deliver market-beating returns.

Q3 – A robust quarter

For the quarter ended September 30th, 2020, General Dynamics reported revenues of $9.4B, just 3.4% lower YoY, and net income of $834M, a decline of 8.7% YoY. The slight decline in turnover and a higher drop in net income may not make for the most charming headline. However, there are two things to remember.

Firstly, the company’s heavy-industrial nature of operations requires a remarkably complex supply chain before the final product is delivered. Considering the challenges caused by COVID-19, the 3.4% reduction in sales is negligible.

Additionally, being a defense contractor, the company’s annualized revenue growth is not particularly important. As with most other companies in the sector, General Dynamics has a huge backlog. As the company keeps on delivering its order book, the most significant metric is how much profit the company can extract to be returned to shareholders. Revenue growth has little weight here as the future backlog and, hence, approximate future revenues are relatively known already. In terms of its net income, we expect margins to resume to their previous, slightly higher levels, as management indicated in their earnings call.

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Source: Seeking Alpha, Author

This brings us to our next point, which is backlog growth. General Dynamics’ total backlog at the end of Q3 was $81.5 billion, up 21% from the year-ago quarter. New contracts, including an $870 million agreement to deliver 8×8 combat vehicles to the Spanish Ministry of Defense and IT and cybersecurity services for the DoD valued approximately at $760 million, point towards a significantly strong demand for the company in the upcoming years, that should keep producing sturdy revenues.

Source: Earnings Release

Finally, future growth is likely to be critically boosted the company’s IT segment, which saw decent revenue growth of around 8%, and significant earnings boost amid higher margins. The segment (21% of revenues) seems particularly promising as its cloud-related operations should be able to keep its margins expanding, while the recurring cash flows should keep adding consistent value to the company’s top and bottom line, reducing the variance caused in financials by its more industrial-heavy segments.

Source: Investor Presentation

Despite its rock-solid operations and near an all-time high backlog, the stock is trading near its 5-year lows, presenting a very attractive opportunity to either initiate a position or double-down to an existing one.

Capital returns, valuation, shareholder expected returns

We believe that, at its current price levels, General Dynamics offers an attractive investment case with a market-beating return potential, backed by its powerful backlog and the following catalysts:

  • Rapid dividend growth, at a comfortable payout ratio.
  • Substantial, consistent buybacks to continue boosting EPS.
  • A surprisingly low valuation, boosting total returns, and DRIPping potential.

The dividend

Growing its dividend annually for the past 26 years, General Dynamics provides real, tangible capital returns that qualify the stock as a great dividend growth play. With a 5 and 10 year DPS CAGR of 10%+, management has been greatly committed to growing shareholders’ income. The latest dividend increase of “just” 7.84% may indicate a potential slowdown for the future growth in distributions, though the rate remains remarkably high still.

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Source: Company Filings, Author

The stock buybacks

Accompanying dividends in the company’s tangible return deliveries, management has been incredibly consistent on repurchasing and retiring its shares. During Q1-Q3, 2020, the company has allocated around $500M in stock repurchases, 116% higher than last year. The company didn’t repurchase any shares during Q3, though we expect buybacks to resume based on the company’s quarterly free cash flow generation of $903M.

Source: Company Filings, Author

For context, since 2007, the company has repurchased and retired nearly one-third of its shares outstanding, significantly advancing EPS and equating fewer aggregate dividends to sustain its rapid dividend growth.

The valuation

Despite its consistent health bottom line and aggressive capital returns, the market has shown little love for the stock over the past years, consistently devaluing shares. At the company’s current guidance for FY2020 EPS of $11.00-$11.10, shares are currently trading at a P/E of 11.9. From a pure earnings perspective, General Dynamics is currently the cheapest aerospace & defense out of the 10 largest cap stocks in the sector.

Investor returns

To estimate our potential medium-term investor returns, we have assumed that EPS grows by 5% over this period. We believe this is a reasonable estimate based on:

  • The company’s organic growth and buybacks showcasing a 10-year EPS CAGR of 6.5%.
  • FY2020 EPS dragged lower amid COVID-19’s challenges and one-off compressed margins.
  • Buybacks to return due to being a traditional capital return strategy of GD, especially effective under the current, cheap valuation.

Additionally, we expect DPS to grow by around 5% as well. This figure should be pretty achievable, considering that we assume additional DPS deceleration despite the very comfortable payout ratio and free cash flow generation levels.

By plugging in our expected growth rates and a set of different future valuation multiples, we get the following results:

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As you can see, shares have the potential to greatly benefit from a potential valuation expansion to what we believe is a more reasonable multiple. Even remaining relatively undervalued at around 14X earnings, we can see shares delivering double-digit returns in the medium return. In contrast, the potential for generating negative annualized returns is extremely unlikely, upheld by a substantial dividend yield of 3.3%.

Source: Author

Conclusion

General Dynamics’ Q3 displayed resilient financials. Despite the challenges caused by COVID-19, the company’s governmentally-sourced cash flows remained robust, which should bolster investor confidence. Instead, shares are currently trading at a 5-year low stock price and valuation, displaying a disanalogous behavior to the company’s underlying performance.

Taking everything into account, we believe that shares remain cheaply priced, offering the potential for market-beating returns, despite what may be prudent growth estimates based on the company’s all-time high backlog. Assuming even a slight valuation expansion, doubling your funds over the next 5-6 years may not be a stretched expectation. At a reasonable P/E of around 15, we can comfortably see the stock delivering annualized returns of around 13%.

While some risks, including compressed margins and COVID-19 persisting, endure, we believe that General Dynamics is one of the most attractive stocks to pick up in the sector. Hence, we remain long.

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Disclosure: I am/we are long GD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com