General Dynamics (GD): A Wide Moat Dividend Aristocrat With Double-Digit Payout Growth Potential

With its 25th straight annual dividend increase, General Dynamics (GD) has finally joined the dividend aristocrats list here.

 

However, even more impressive than the length of this streak is the torrid pace of payout growth GD investors have enjoyed.

 

Specifically, the company has grown its dividend at 14.1% annually since 1992, helping General Dynamics’ shares nearly double the broader market’s annual total return (15.7% vs 8.8%).

 

Let’s take a closer look at this defense contractor to see what gives it such a wide moat and allows it to treat dividend growth investors so well.

 

More importantly, learn if GD’s excellent payout growth track record is likely to continue for many more years to come.

 

Business Overview

Founded in 1899 in Falls Church, Virginia, General Dynamics grew largely through acquisitions of military-related companies until the 1990s when it decided to sell off most of its businesses.

 

The company then started expanding again by acquiring combat vehicle businesses, information technology (IT) companies, shipyards, and Gulfstream Aerospace Corporation.

 

Today, General Dynamics is one of the world’s leading global aerospace and defense companies that sells everything from business jets to submarines to combat vehicles to IT communications systems.

 

The company’s 100,000 employees are located across more than 40 countries and operate four business segments:

 

Aerospace (27% of 2016 revenue, 40% of 2016 operating profit): designs, develops, manufactures, and outfits business-jet aircraft (Gulfstream, which commands 30% global market share), as well as provides aircraft services, such as maintenance, repair, aircraft management, charter, fixed-base operational, and staffing services. It also performs aircraft completion services for other original equipment manufacturers. Its operating history dates back more than 50 years.

 

 

Combat Systems (18% of revenue, 21% of operating profit): designs, develops, produces, and modernizes, combat vehicles, weapons systems, and munitions. This group offers wheeled combat and tactical vehicles including main battle tanks and tracked combat vehicles, as well as providing armaments and maintenance and logistics support and sustainment services.

 

 

Information Systems and Technology (29% of revenue, 23% of operating profit): provides technologies, products, and services that support a range of military, federal/civilian, state, local, and commercial customers. This group offers IT solutions and mission support services; communication, command-and-control, and computer mission systems including imagery, signals, and multi-intelligence systems for customers in the defense sector, intelligence and homeland security communities, as well as foreign governments allied with the U.S.

 

 

Marine Systems (26% of revenue, 17% of operating profit): designs, constructs, and repairs surface ships and submarines for the United States Navy and Jones Act ships for commercial customers. This group offers nuclear-powered surface combatants, auxiliary and combat-logistics ships, and commercial product carriers and containerships. It provides design and engineering support services, as well as maintenance, modernization, and lifecycle support services.

 

 

Most of General Dynamics’ revenue is from the U.S. Government (60%) with the remainder from U.S. commercial customers (15%), and international commercial and military customers (25%).

 

Business Analysis

General Dynamic’s strong record of dividend growth and excellent long-term total returns is driven by the company’s wide competitive moat. This is particularly true with regards to its Department of Defense (DoD) business, in which the military only works with a few trusted companies, with proven expertise in delivering on important weapons programs and IT services platforms.

 

For example, due to the need for more advanced ships with all-electric propulsion, stealth characteristics, electromagnetic catapults, and advanced weapon systems, General Dynamics and Huntington Ingalls Industries (HII) have a duopoly in this industry, as they control the only five shipyards that build U.S. Navy vessels.

 

When the Navy needed someone to build 28 Virginia class nuclear attack submarines, as well as 12 Columbia class ballistic missile subs, General Dynamics was one of the few companies with the facilities and technical background to get the job done, so it won the primary contractor position on both.

 

Another part of GD’s moat is the complex nature of military contracts, most of which are fixed-price, cost plus arrangements (32% of total revenue in 2016) that take years to bid on and finalize.

 

Most cost overruns are shouldered by the company and thus smaller firms, who might not survive year-long delays and higher-than-expected costs ,are generally not seriously considered by the Pentagon.

 

There are only so many government contracts to win each year, too. Fortunately, many of the company’s defense businesses have been around for a very long time. Some of them even have roots dating back to the 19^th century.

 

With so much operating history, General Dynamics has built up very strong relationships with government officials and established a reputation of quality and reliability. New entrants would have a hard time breaking through the strong customer bonds enjoyed by incumbents, especially given the limited number of contracts up for grabs each year.

 

Finally, foreign weapons exports are incredibly complex and fall under International Traffic in Arms Regulations that few smaller companies can comply with.

 

On the commercial side, building business jets is a capital intensive and complex endeavor, in which few companies dare to tread.

 

In addition, because of the life and death nature of aircraft, businesses prefer companies with long track records for safety, as well as those large enough to provide ongoing maintenance and upgrades over the course of a jet’s useful life.

 

Gulfstream benefits from strong brand recognition and its dominant support network. In fact, this business boasts the largest service network in the business aviation industry with service centers located on four continents, including the largest aircraft maintenance facility in the world. Gulfstream was also the first manufacturer to open a service facility on mainland China.

 

Business customers fly their jets around the world and need a vendor that can quickly repair and service their jets if any issues arise. This has helped Gulfstream maintain a strong market share and generate meaningful aftermarket business.

 

The lack of numerous competitors in both its defense and aerospace businesses, combined with General Dynamics’ massive size, which allows it great economies of scale, results in not only above average margins and returns on capital, but profitability that has consistently increased over time.

 

General Dynamics Trailing 12-Month Profitability

 

Another major factor explaining why General Dynamics has been such a dependable dividend growth stock is the long-term nature of its contracts.

 

For example, at the end of 2016, General Dynamics had a $60 billion backlog representing nearly two years worth of sales, helping to ensure relatively predictable cash flow that can be returned to shareholders in the form of buybacks and quickly growing dividends.

 

The company’s large base of aftermarket services revenue, which is less sensitive to customer spending trends, provides further stability.

 

 

Key Risks

There are four key risks to consider before investing in General Dynamics.

 

First, keep in mind that this industry is cyclical and highly capital intensive, meaning that sales and earnings can be somewhat volatile.

 

 

For example, due to the war on terror, specifically the wars in Iraq, and Afghanistan, defense contractors enjoyed very strong business conditions between 2002 and 2009.

 

However, as those wars have wound down, new contracts have slowed (25% reduction in defense spending between 2008 and 2015, according to research from Morningstar), making General Dynamics more reliant on its commercial aerospace segment.

 

And thanks to the extremely generous profit margins enjoyed by Gulfstream (about double that of its rivals), the very strong business jet market in recent years has allowed GD to offset flat sales growth with ever higher margins (now at all-time highs), which have kept earnings growing nicely.

 

While aerospace cycles will ebb and flow over long periods of time, General Dynamics is also in the middle of a transition from legacy aircraft products to new models (specifically from the Gulfstream 500 series of jet to the new 600 series).

 

Production rates are coming down for its old models, and management hopes to hold sales and earnings flat the next several years before returning to growth with the new models in 2018-19 and beyond.

 

In the coming few years, GD’s transition seems likely to result in some margin pressure in its highest margin business segment. Given the capital intensity of manufacturing aircraft, there is plenty of risk when product transitions are being made.

 

General Dynamics could run into unexpected challenges that lead to higher costs or unfavorably alter production schedules. Longer term, however, this seems like a good business that will see higher demand resulting from increased international business travel.

 

But remember that commercial aircraft is still a cyclical business (generally trailing corporate earnings growth by 12 to 18 months). If the global economy fall into a recession, than GD’s top money maker (Gulfstream represents 40% of profits) could see a sharp decline in orders.

 

 

Next, there’s the inherent political uncertainty surrounding defense spending which accounts for nearly 60% of GD’s sales.

 

While it’s true that President Trump has called for $54 billion in addition defense spending, including an expanded 355 ship Navy (82 more ships than we have today), more tanks, and a new generation of nuclear weapons (as well as allowing for more foreign weapons sales to allies), there is a big difference between proposed policies and those that actually make it through Congress.

 

After all, this entire year has been a hard lesson in how bad Congressional gridlock can be, even when a single party controls all three branches of government.

 

And as we’ve seen with the Littoral Combat Ship, even already awarded contracts can end up being shortened or even cancelled if the military’s needs and budgetary constraints change.

 

The Columbia class of ballistic missile submarines in particular requires $80 billion in funding, which Congress reassesses on an annual basis. Should the political winds shift, it’s possible the Navy may be forced to choose between these new boomers and other vessels, such as the Gerald Ford, America’s latest generation of Aircraft Carrier. The Ford, commissioned in July of 2017, ended up costing $13 billion, $2.4 billion more than expected.

 

The Navy plans to spend $43 billion in total on the first three of the new Ford class carriers.  That’s about 11% of the $400 billion the Navy plans to spend over the next 30 years on new ships.

 

Beyond somewhat unpredictable defense spending levels, it’s worth mentioning that fixed-price contracts account for over 30% of General Dynamics’ total sales.

 

These contracts contain higher risk because General Dynamics is on the hook for any cost overruns or delays. However, this risk shouldn’t impact the company’s long-term earnings power and would likely be more of a buying opportunity if it arose.

 

Finally, don’t forget that 25% of General Dynamics’ sales come from overseas, which exposes a fair portion of its sales, earnings, and cash flow growth to the risks of a strong dollar (resulting in foreign sales converting to less U.S. dollars).

 

General Dynamics’ Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

General Dynamics’ has a Dividend Safety Score of 99, indicating an extremely dependable payout, which is what one would expect for a dividend aristocrat that’s been raising its dividend every years since 1992.

 

There are two key factors that explain General Dynamics impressive ability to maintain a very safe, yet steadily growing dividend. The first is the highly conservative EPS and FCF payout ratios, which ensure that even in down years the dividend is well insulated and never at serious risk of a cut.

 

As seen below, the company’s EPS payout ratio has remained near 30% or below for the last decade. This is a very healthy level – even if General Dynamics’ earnings were unexpectedly cut in half, its payout ratio would only rise to about 60%, providing plenty of safety to continue paying the dividend.

 

 

Such a drop in earnings is unlikely for a company like this, which further insulates the dividend. Demand for General Dynamics’ products is driven more by trends in government defense spending and the business jet cycle, which don’t always match up with trends in the broader economy.

 

Each of these businesses has different drivers, which diversifies the company’s cash flow and has helped General Dynamics better weather the severe defense cuts rippling through the industry over the last five years. Long-term customer contracts and large aftermarket revenue streams also help stabilize growth.

 

The other important safety factor is the company’s fortress-like balance sheet, courtesy of its strong current ratio (short-term assets/short-term liabilities), modest net debt position, and free cash flow that comfortably covers the dividend nearly twice over.

 

 

However, remember that defense contracting is a very capital intensive industry, which means that to truly get a sense for how strong GD’s balance is we need to compare to its peers.

 

 

When we do, we find a leverage ratio (Debt/EBITDA) that’s about three times smaller, a debt to capital ratio that’s less than half, and a very high interest coverage ratio, which helps to secure GD a very strong investment-grade credit rating.

 

That in turn allows the company to borrow at an average interest rate of just 2.4% (barely above the 10-year U.S. Treasury rate), thus providing management with financial flexibility to grow the company while still providing one of Wall Street’s safest and steadiest growing dividends.

 

Overall, General Dynamics’ excellent profitability, low payout ratios, stable cash flow, and healthy balance sheet make its dividend payment one of the safest in the market.

 

General Dynamics’ Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

General Dynamics’ Dividend Growth Score of 67 indicates that dividend investors can probably expect above average payout growth in the years ahead. That’s not surprising given that GD has historically grown its dividend at double-digit rates.

 

 

Going forward investors should expect the dividend to rise in line with EPS and FCF per share.

 

Fortunately, thanks to increased foreign weapons sales, a recovery in corporate jet sales that is currently underway, as well as a very strong history of buybacks (which lowers the payout ratio and allows for longer, stronger dividend growth), General Dynamics has potential to generate 8% to 10% bottom line growth in the coming years.

 

That in turn should allow it to continue growing the dividend around 10% a year for the foreseeable future.

 

Valuation

In the past year, thanks to heightened expectations surrounding increased military spending, as well as hopes for lower corporate taxes, General Dynamics shares have returned close to 45%, significantly outperforming the S&P 500. Unfortunately, GD now appears to be overvalued.

 

For example, GD’s forward P/E ratio of 20.2 is not only higher than the S&P 500’s already lofty forward P/E of 18.1, but it is also much higher than its historical norm of 15.4.

 

Regarding dividend yield, GD’s current yield of 1.6% is slightly below the S&P 500’s 1.9% and its five-year average yield of 2.1%. In fact, you can see that GD’s current dividend yield is the lowest it has been over this time period.

 

 

These measures indicate that General Dynamics is somewhat overvalued relative to history, though perhaps not as much as some of its rivals who have also benefited from the so-called “Trump bump.”

 

The stock’s low dividend yield also means that General Dynamics isn’t a great candidate for retired investors looking to live off dividends (check out some of the best high dividend stocks here instead).

 

Waiting for a somewhat better entry price is probably a good idea, although the wide moat and high caliber of the company makes it worth watching.

 

Conclusion

When it comes to defense contractors, they don’t get much better than General Dynamics. The long-term focused management team has done a great job of maximizing margins and maintaining one of the strongest balance sheets in the industry.

 

The company’s aerospace and defense businesses possess numerous competitive advantages and appear poised to deliver healthy earnings growth over the coming years, which should continue to make GD one of the most dependable dividend growers in the market.

 

That being said, today’s share price appears to be somewhat rich, indicating that it might be best to wait for a pullback before giving this latest dividend aristocrat more consideration for a diversified dividend growth portfolio.