Description

Investment Profile:

General Dynamics is an $80BN market cap / $89BN EV global aerospace and defense firm with a portfolio of businesses that are leading franchises in each of their respective markets. GD is based in Reston, VA but has operations around the world. The Company was formed in 1952. Over the years, the company has grown into one of the largest defense primes and aerospace companies primarily via strong business and M&A execution. Today, the company generates $42.3BN revenue, $3.3BN net income and $3.8BN of FCF. Additionally, the company has a strong balance sheet with $8.2BN of net debt which equates to a leverage ratio of ~1.5x.

In my view, the investment thesis hinges on three main points:

1. Strength of Gulfstream business: Gulfstream's product portfolio, healthy backlog ($21BN), recent new product introductions, and safety history make Gulfstream the leading business / private jet company in the world. I believe these factors can mitigate cyclical slowing and lead to an extended upswing. GD's new products (G700, G800, G400) address attractive niches with share gain potential and design commonality to boost productivity and profitability. Specific to the G700, the model received FAA certification in late March of this year. Production and deliveries have already commenced with the company expecting to deliver ~50 planes this year. The market was concerned about the businesses’ margins being lower in Q1. I believe these concerns are misplaced and that margins will ramp over the remainder of the year to management’s original guidance of 15% as R&D / investment tapers off. More broadly speaking, the business jet market has remained extremely robust with no real signs of slowing any time soon.
2. Defense business aligned with DoD priorities: GD’s defense business is less high profile than LMT and NOC but addresses key initiatives for the DoD including munitions replenishment, China's push for Taiwan (subs/ships), Russian aggression (European vehicles), and cyberattacks (GDIT). Re the Marine business, I encourage those interested to read the news articles in murman’s recent write up on HII which highlight the underinvestment over the last several decades in US Navy ship / submarine building and consequently the pressing need for the US and allies to significantly increase spending and investment in these specific areas. GD’s Marine business has an extremely long runway of growth as evidenced by the current backlog of $44BN. I also believe the opportunity in both Combat Systems and Technologies is attractive driven by ammo replenishment and land vehicle products. Combat Systems and Technologies have a combined $58BN backlog.
3. Capital deployment to increase EPS growth: FCF increased to $3.8BN (115% earnings conversion) in 2023. Conversion is expected to remain over 100% in 2024 and 2025 enabling the company to return cash via high single digit dividend increases and ~$2.0BN annual repurchases – with potential for an additional $6BN+ repurchase. In Q1, the company repurchased 390K shares for $105MM on worries around a government shutdown which sets the stage for much higher repurchases over the remainder of the year. Consider over the last 10 years, the company has repurchased an average of 3.5% of shares annually.

In summary, GD is a well diversified prime with leading products and solutions in their areas of focus that have attractive long term growth prospects. Valuation is reasonable at 14x EBITDA, 18x earnings, and 5.6% FCF yield. Based on the tailwinds across each of its businesses, I think GD can grow EPS low to mid teens for the foreseeable future which will be augmented by capital returns. Further, geopolitical tensions continue to rise which should support healthy DoD spending for years to come. All in all, I think the shares can compound annually in the mid teens.

Business Summary:

GD is a global aerospace and defense company that specializes in high-end design, engineering and manufacturing of products and services in business aviation; ship construction and repair; land combat vehicles, weapons systems and munitions; and technology products and services. The US Government / DoD accounts for 72% of total sales. The Company has 10 business units under 4 operating segments:

• Aerospace (20% of sales / 27% of OI): Leading producer of business jets and the standard bearer in new technology aircraft, aircraft repair, support and completion services. The segment consists of the Gulfstream and Jet Aviation business units. Gulfstream offers a diverse portfolio of 8 different types of luxury jets that address all segments of the market. There are more than 3,000 Gulfstream jets around the world in service that they provide MRO services to. Jet Aviation provides a comprehensive suite of innovative aircraft services for aircraft owners and operators around the world. Jet Aviation manages ~300 business aircraft globally on behalf of individuals and corporate owners out of its ~50 global locations. Below is Gulfstream’s current product lineup.

• Marine Systems (30% of sales / 20% of OI): Designs and builds nuclear-powered submarines and surface combatant and auxiliary ship design and construction for the US Navy. Marine also provides maintenance, modernization and lifecycle support services for Navy ships. Marine Systems consists of three business units — Electric Boat, Bath Iron Works and NASSCO. Electric Boat is the prime contractor and lead shipyard on all Navy nuclear-powered submarine programs. The business is responsible for all aspects of design and engineering and leads the construction of both Columbia-class ballistic-missile submarines and Virginia-class attack submarines. Bath Iron Works builds the Arleigh Burke-class (DDG-51) guided-missile destroyer and manages modernization and lifecycle support for all Navy destroyers. NASSCO specializes in Navy auxiliary and support ships and is currently building the Expeditionary Sea Base, which serves as an afloat forward-staging base for US Marines and special operations forces, and the John Lewis-class (T-AO-205) fleet replenishment oiler. Below is the current programs, final scheduled delivery date and backlogs as of year end 2023.

• Combat Systems (20% of sales / 26% of OI): Manufactures land combat solutions worldwide, including wheeled and tracked combat vehicles, weapons systems and munitions. The segment consists of three business units - Land Systems, European Land Systems (ELS), and Ordnance and Tactical Systems (OTS). Land Systems is the sole-source producer of two products central to the US Army’s warfighting capabilities — the Abrams main battle tank and Stryker wheeled combat vehicle. ELS produces Piranha vehicles, a premier 8x8 armored combat vehicle. ELS also provides mobile bridge systems and the ASCOD - a highly versatile tracked combat vehicle. OTS designs, develops and produces a comprehensive array of sophisticated weapon systems for ground forces. OTS produces next-generation weapon and defense systems for shipboard, aircraft and ground applications, including high-speed Gatling guns for all US fighter aircraft (such as the F-35 Joint Strike Fighter) and combat vehicle active protection systems (Hydra-70 rockets). Below is the installed base for Combat Systems vehicle programs as well the quantity and scheduled final delivery date of vehicles and vehicle upgrades in backlog.

• Technologies (31% of sales / 27% of OI): Provides a full spectrum of services, technologies and products to a market that increasingly seeks solutions combining leading-edge electronic hardware with specialized software. The segment is organized into two business units — Information Technology (GDIT) and Mission Systems. Together they serve a wide range of military, intelligence, federal civilian and state customers with a diverse portfolio that includes: (1) consulting, technology solutions and mission-support services; (2) mobile communication, computers, command-and-control and cyber mission systems; and (3) intelligence, surveillance and reconnaissance solutions.

Valuation:

Despite a better growth outlook and higher cash conversion, GD trades in line with its public peer average. Based on the forward growth opportunity driven by the secular tailwinds I have described above, I think GD can trade at a premium to the peers and should trade at a market multiple (S&P 500 currently trading at 23.5x forward). GD’s reasonable FCF and dividend yields should help mitigate some downside risk.

Management:

Phebe Novakovich was named Chairman and CEO in January 2013. During her time at the helm, the stock has compounded at a 15.8% CAGR compared to the S&P 500’s 14.6% CAGR during the same time period. While this has been a challenging time for the defense industry, sales have increased ~$11BN during her time as CEO and overall margins have remained very stable. A focus of hers has been FCF conversion which has been above 100% for the last 3 years. She has also focused on capital return - GD has paid $11.7BN dividend since 2012 and has repurchased $17.0BN worth of shares. Total common shares outstanding have declined by nearly 30% over her tenure. Prior to being named CEO, Phebe had been with GD since 2002 serving in various senior roles including COO and EVP of the Marine business. Before joining GD, she held senior positions at both the CIA and DoD.

Key Risks:

• Supply chain risk: The Marine and Gulfstream businesses have been most heavily impacted by the supply chain challenges post COVID. However, the situation is improving
• Labor productivity: Still remains an issue for GD but appears to be easing
• Lower DoD spend: Given the rising geopolitical conflicts, this seems like a low probability
• Recession: Macro weakness would negatively impact Gulfstream but could be somewhat less severe than previous periods of weakness given backlog. Further, its likely that government spending would increase during a recession which should bolster the Defense businesses

Catalyst

Capital Return

Business execution

Geopolitical tensions

Increasing military spend