Bulk Up with this Defense Stock
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For investors wanting exposure to the defense industry, General Dynamics Corp. (NYSE: GD) is one of the best bets for long-term gains. The fourth largest defense contractor in the world, this U.S. based company is involved in all aspects of war. Throughout its 50-plus year history, GD has developed vehicles used in the realms of land, water, and air, though it has placed a recent emphasis on technologies used for cyber warfare. In fact, while GD is most famous for its development of machines like the F-16 fighter jet, the company generates the largest fraction of revenues from its information systems and technology branch. Since the start of 2012, shares of the company have risen a modest 4.62 percent to nearly $70 a share, though it seems that this bull still has a lot of room to run. GD is adored by a number of hedge funds, operates in a favorable macroeconomic climate, and is currently undervalued by a number of metrics when compared to its peers in the defense industry.
Looking at hedge fund activity, we can see that this stock is a darling of 30 different fund managers, and is the third most popular defense stock according to this recent article. The funds with the largest holdings of GD are Longview Asset Management, Edinburgh Partners, Polaris Capital Management, and Farallon Capital, all of which have at least $1 billion in assets under management. Part of this popularity can be attributed to the favorable economic environment that GD operates in. As of the end of last year, the company received close to 72 percent of its revenue from the Department of Defense, a relationship that has only grown stronger in recent months. In early February, the company won a significant portion of a $476 million contract to provide information technology services to the DOD’s Omnibus Network Enterprise program, which will encompass a number of governmental agencies. As mentioned above, IT services account for the most significant portion of GD’s revenues – amounting to 34 percent of 2011’s yearly total. The other branches of GD – combat systems, marines systems, and aerospace – account for 27%, 20%, and 18% respectively.
In the wake of mounting deficits, the Department of Defense has announced that it will cut around $480 billion from its budget in the next decade. This is a risk affecting all defense stocks, though GD may be one of the best bets to ride out this austerity. While it does receive 72 percent of its revenue from the government, GD is less exposed to cuts than most of its competitors: Lockheed Martin Corp. (NYSE: LMT) at 75%, Raytheon Company (NYSE: RTN) at 90%, Northrop Grumman Corp. (NYSE: NOC) at 90%, and SAIC, Inc. (SAI) at 93% are all higher, though Boeing Co. (NYSE: BA) at 48% is more diversified. Interestingly, the DOD has also announced that funding for cyber technology will increase over the next 10 years. This move helps GD, as it receives the highest fraction of its revenues (34%) from this area. In dollar terms, the company generated over $11 billion from cyber tech in 2011, which was considerably more than any of its competitors.
Aside from this connection with Uncle Sam, GM receives a significant portion of its remaining revenue from private jet operations. After acquiring Gulfstream Aerospace in 1999, GD has been able to add the popular Gulfstream business jet to their sales floor, a move that has since contributed an average of $4 billion in annual revenues. In recent years, the private jet business has been booming, no pun intended, and has been primarily driven by an increased demand from emerging markets in Asia. In 2011, the company’s Gulfstream backlog rocketed to a post-recession high of $18.6 billion. Over the next ten years, it is expected that over $40 billion worth of private jets will be sold here, and General Dynamics is in a prime position to take a significant chunk of this as it currently accounts for nearly 50 percent of all private jet sales in the Asian region.
When comparing GD with its competitors, we can see that the stock is undervalued, even though the company itself is a solid revenue generator. Over the last 3 years, GD has experienced an average revenue increase of 3.7 percent, which is higher than the industry average of 2.2 percent. In addition, we can see that most of its competitors – LMT (2.9%), RTN (2.4%), NOC (-6.5%), and SAI (1.7%) – are growing more slowly. Only BA has had a larger 3-year average revenue growth (4.1%), though valuation ratios show that it is grossly overvalued in comparison to GD. In fact, GD is one of the most undervalued stocks in its industry when we look at Price-to-Earnings and Price-to-Free Cash Flow ratios. GD’s P/E ratio is 10.0X, which is below the industry average of 13.5X. This is also below LMT (11.6X), BA (13.8X), RTN (10.2X), and SAI (67.6X). While NOC (8.2X) has a lower P/E, it is not a better investment than GD because its revenues are actually shrinking, as seen above. Additionally, GD has an attractive P/FCF ratio of 12.8X, which is below most of its competitors including LMT (14.4X), BA (53.1X), RTN (16.7X), and NOC (14.5X). Only SAI (7.0X) is lower, though its total free cash flow is about one-fifth the size of GD’s.
In short, GD gives shareholders solid growth now, with an even greater upside in the future. If Uncle Sam continues to love cyber technology and GD’s private jet business stays on course, this undervalued defense stock will be a good bet over the next few years. General Dynamics Corp. is a buy.
The Motley Fool owns shares of General Dynamics, Lockheed Martin, Northrop Grumman, and Raytheon Company. This article is written by InsiderMonkey author Jake Mann. He has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.