General Dynamics (GD) is a unique dividend growth stock because it has significant exposure to defense markets but is also a major manufacturer of business jets, resulting in a rather diversified stream of cash flow. The company has increased its dividend or 24 straight years and appears likely to join the dividend aristocrats list this spring.
With long-term contracts, sticky customer relationships, and high barriers to entry enjoyed in many of its markets, it’s no wonder why General Dynamics has delivered double-digit dividend growth for over a decade. Warren Buffett also used to own General Dynamics and even had a 14% stake in the company back in the early 1990s (see all of Warren Buffett’s current dividend stocks by clicking here).
Let’s take a closer look at General Dynamics as we consider it for our Top 20 Dividend Stocks portfolio.
Business Overview
General Dynamics was founded in 1952 and grew largely through acquisitions of military-related companies until the 1990s when it decided to sell off most of its businesses. The company started expanding again by acquiring combat vehicle businesses, information technology (IT) companies, shipyards, and Gulfstream Aerospace Corporation.
Today, General Dynamics is a leading global aerospace and defense companies that sells everything from business jets to submarines to combat vehicles to IT communications systems. Approximately 64% of sales are related to products with the remaining 36% tied to services.
Most of General Dynamics’ revenue is from the U.S. Government (57%) with the remainder from U.S. commercial customers (17%), international commercial customers (13%), and international government customers (13%).
Segments
Aerospace (28% of revenue; 40% of operating earnings): delivers Gulfstream aircraft, primarily business jets. The company’s product portfolio focuses on the large- and mid-cabin business jet market. Its operating history dates back more than 50 years.
Combat Systems (18% of revenue; 21% of operating earnings): sells a broad range of combat vehicles and weapon systems primarily for the U.S. It specializes in light armored vehicles. Sales have been declining by roughly 2% per year the last few years.
Information Systems and Technology (29% of revenue; 21% of operating earnings): General Dynamics builds a range of IT networks and advanced communications systems for military, government, and commercial customers. Sales declined by 2% last year and 10% the year before.
Marine Systems (25% of revenue; 18% of operating earnings): sells nuclear submarines and other ships to the U.S. Navy.
Business Analysis
General Dynamics has been able to earn strong returns on invested capital primarily because the barriers to entry in most of its markets are so high. Given the meaningful differences between its aerospace and defense-related businesses, we will analyze them separately.
On the defense side, many of the company’s businesses have been around for a very long time. Some of them even have roots dating back to the 19th 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 considering the limited number of contracts given out by the government each year.
Supplying the government with submarines and tanks is also extremely capital intensive. For example, the company’s Virginia class submarine program is ramping up production from one submarine per year to two submarines per year – that’s how massive the construction work is to build a world-class submarine.
Defense contractors must also comply with substantial government regulations and oversight. To further complicate things, the majority of General Dynamics’ contracts with the government are fixed price deals rather than cost-plus arrangements. In other words, the company is on the hook for any cost overruns or delays. Smaller competitors are not financially strong enough to take on these risks, eliminating them from the pool of contractors that the government will consider.
On the business jet side of General Dynamics’ business, the company benefits from strong brand recognition and a dominant support network. The company’s Gulfstream business operates 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. While there are many more competitors in this market than there is for Boeing in large commercial aircraft, significant development costs and regulatory hurdles also limit new entrants to an extent.
General Dynamics’ aerospace and defense-related businesses have helped the company amass a backlog valued at over $66 billion at the end of 2015, representing over two years of revenue. Business volatility is further reduced by General Dynamic’s long-term contracts with customers and large base of aftermarket services, which are less sensitive to customer spending trends.
While weakness in defense spending has hurt the company’s growth over the last five years, management is optimistic that all four of its segments could begin growing together over the next five years for the first time in a long time. Growth in international defense business is serving as a major driver despite currency challenges at the moment, and it appears the defense spending is stabilizing. However, the company’s optimism is subject to a number of risks.
General Dynamics’ Key Risks
In General Dynamics’ aerospace business, which generated 40% of profits last year, there is risk that the corporate jet sales cycle will begin to slow down after several strong years of growth. Sluggish global growth is denting international demand, and Gulfstream recently laid off over 1,100 employees, the most since the financial crisis.
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. 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.
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, we continue to think this is a good business that will see higher demand resulting from increased international business travel.
The company’s defense-related businesses have given it the most challenge over the last five years. U.S. defense spending has been reduced as operations in the Middle East wound down and fiscal budgets became even more stretched.
While the Bipartisan Budget Act of 2015 raised the government’s spending cap by $25 billion and $15 billion for fiscal year 2016 and 2017, respectively, there is still plenty of uncertainty. The upcoming political election cycle makes the picture even murkier. However, based on information known today, the defense spending bill passed by Congress in late 2015 would increase spending by roughly 2% in fiscal year 2016 to about $573 billion.
Another risk to consider is where defense spending goes. Military operations have evolved significantly over the last decade. The risk is that General Dynamics’ military products become less relevant in today’s combat world (e.g. less tanks, more drones). The company’s expertise across numerous defense programs and close relationships with the government should help it stay relevant, but it’s worth monitoring.
Beyond 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, we don’t believe this risk impacts the company’s long-term earnings power.
Dividend Analysis: General Dynamics
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. GD’s long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
General Dynamics’ Dividend Safety Score of 99 suggests that its current dividend payment is safer than 99% of all other dividends available in the market. The company’s strong safety rating begins with its earnings payout ratio, which stands at 30% on a trailing 12 months basis.
As seen below, the company’s earnings payout ratio has remained below 30% for the last decade. This is a really healthy level – even if General Dynamics’ earnings were unexpectedly cut in half, its payout ratio would only rise to 60%, providing plenty of safety to continue paying the dividend.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
Analyzing a company’s cyclicality also helps us evaluate the safety of its dividend. A low payout ratio can be misleading if a company is cyclical and near peak demand. Looking below, we can see that General Dynamics’ sales growth has remained quite stable over the last 10 years and actually grew during the last recession, which helped its stock slightly outperform the S&P 500 in 2008.
Demand for the company’s 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 also 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.
Source: Simply Safe Dividends
Despite weak top line growth, General Dynamics has done an excellent job maintaining its free cash flow. As seen below, the company has generated positive free cash flow in each of the past 10 years, highlighting the profitability of its customer contracts and the reliability of its aftermarket business. Consistent free cash flow generation raises the safety of the dividend.
Source: Simply Safe Dividends
The company has also earned a strong return on invested capital over the last decade and saw its return surpass 20% for the first time last year. Companies that earn high returns typically have competitive advantages and are able to compound their earnings faster. General Dynamics has also taken a lot of costs out of its business in response to lower defense spending, which has made its businesses more competitive and prepared for better earnings growth with demand strengthens.
Source: Simply Safe Dividends
General Dynamics also maintains a very healthy balance sheet. The company’s Net Debt / EBIT ratio of 0.1 means that it could retire all of its debt with cash on hand and about one month’s worth of earnings before interest and taxes (EBIT). The company also has around $3 in cash on hand for every $1 of dividends it paid out last year.
Source: Simply Safe Dividends
General Dynamics’ excellent free cash flow generation, low payout ratios, high returns on capital, stable sales growth, and healthy balance sheet make its dividend payment one of the safest in the world.
Dividend Growth Score
Our 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 has a Dividend Growth Score of 79, which suggests that it has excellent dividend growth potential. The company most recently increased its dividend by 11% in 2015, marking its 24th consecutive calendar year of higher dividend payments and positioning the company to join the dividend aristocrats list this year.
As seen below, General Dynamics has consistently grown its dividend at a double-digit rate, including 13.2% annual growth over the last 10 years. With low payout ratios and potential for accelerating earnings growth over the next five years, we believe high-single digit to low double-digit dividend growth will continue.
Source: Simply Safe Dividends
Valuation
GD’s stock trades at 14.4x forward earnings estimates and has a dividend yield of 2.0%, which is below its five-year average dividend yield of 2.4%.
The company has done an excellent job of growing its earnings per share by 5.9% per year over the last five years despite an annualized 0.6% decline in revenue.
With the stock trading at a relatively high earnings multiple and dividend yield compared to its history, it would appear that investors are beginning to price in better growth prospects ahead.
If management is correct that all four of the company’s segments can begin growing together as we head towards the end of this decade, we believe General Dynamics’ earnings could grow at a high-single digit rate, which would imply total return potential for the stock of 9-11% per year.
We think GD’s stock is fairly valued today, especially given the amount of uncertainty with a new political election cycle and constantly changing government budgets.
Conclusion
General Dynamics has numerous competitive advantages that make it a free cash flow machine and certainly a blue chip dividend stock. However, it is hard for us to get comfortable with the fundamental risks facing the company over the next five years. Given the market’s increased expectations for earnings growth, we would prefer to revisit the stock when its valuation is lower.
Excellent article and analysis, SDD. I’ve had similar reservations as you mention in the Threats section of the business analysis. The combat systems are evolving and the push seems to be more towards drones rather than tanks. I do find it interesting that they are ramping up the submarine production.
Gives me a lot to think about. Thanks for another detailed analysis. Any plans on doing the competitor such as LMT, RTN, NOC etc?
Thanks, R2R. Some of the defense companies are tough given the murkiness clouding their underlying business drivers. LMT is on my list to take a look at soon, too. Thanks for stopping by!
– Brian
Any thoughts of adding a defense stock (outside BA) to one of your portfolios? LMT seems especially interesting given it’s strong dedication to shareholder return.
Hi rcalhoun,
I own FLIR in our Long-term Dividend Growth portfolio. A meaningful chunk of FLIR’s business is tied to defense spending. I’ve generally preferred to avoid government-dependent parts of the market because there is more outside of companies’ control. LMT is a great business and one that I will add to my list to research.
Thanks,
Brian