Description

GENERAL DYNAMICS (GD)

INVESTMENT SUMMARY

General Dynamics (GD) is a cheap, well-run company with terrific competitive positioning in the defense and private aviation industries. GD’s defense businesses include the sale of combat vehicles, weapons systems and ammunition, ships and submarines, and communications and IT services. The aviation business consists primarily of the sale of Gulfstream private aircraft, as well as a private jet services business. While GD’s defense business will surely be pressured in the current budget environment, the decline will likely be more than offset by strong growth at Gulfstream and effective capital allocation. The Aerospace segment should represent 50% of the company’s earnings by 2016 (from 22% in 2011), driven by the launch of the high-margin G-650 aircraft, Gulfstream’s new top-of-the-line jet.

At 10x P/E, GD’s valuation does not reflect the likely robust growth in Gulfstream earnings. Rather, GD’s multiple is reflective of the overall defense spending environment. Over the next five years, GD should average high single digit EPS growth, even assuming a significant hit to defense-related earnings. We believe an investment in GD is an excellent risk/reward with low risk of capital loss.

THE BUSINESSES

Aerospace (18% of CY11 Revenue and 22% of CY11 EBIT)

GD’s aerospace group designs, manufactures and outfits mid-size and large cabin business jet aircraft, and provides maintenance, outfitting and aircraft services for U.S. and international customers. More than 90% of Gulfstream earnings are tied to sales of its large cabin aircraft (models G450-G650s). Gulfstream has ~40% market share in the large cabin segment, and competes against Bombardier (~30% share) and Dassault (~20% share).

Gulfstream is the leader in the stable, growing large cabin business jet market. The large cabin segment, which caters to the ultra-rich, is significantly less cyclical than the middle and lower end of the market. For the typical buyer of a top-of-the-line $50mm+ jet, asset price fluctuations and credit availability do not significantly affect the affordability of a new plane. Gulfstream also has a large and stable backlog. Contracts require progressive milestone payments of several millions dollars, such that breaking a contract is very expensive—the company experienced few cancelations, even during the recession. Industry wide, large cabin jet sales only declined 6% in 2009, and rebounded in 2010.

The large cabin jet market is also marked by high brand loyalty—customers rarely switch brands when upgrading to a new jet. Gulfstream has high and favorable brand recognition worldwide, especially in the U.S. and in emerging markets. While Bombardier and Dassault have their share of loyal customers, Gulfstream is widely seen as the premier business jet brand. In addition to cache, Gulfstream stacks up well against the competition with respect to the key metrics by which buyers evaluate aircraft: safety, reliability and service. Moreover, in the key large cabin industry segment, the G550 and G650 surpass comparable aircraft in range, speed, and generally comfort as well. Gulfstream’s premier reputation allows the company to charge a premium and earn industry-leading margins.

Sales of large cabin jets should continue robust growth, driven by strong demand from international buyers, especially the new ultra-rich in emerging markets. While Gulfstream’s installed base is only 20% international, 60% of its backlog comes from buyers overseas. Private jet penetration in emerging markets, which today is quite low despite a large and growing number of billionaires, should continue to rise as private airports and other infrastructure improve. Emerging market billionaires, especially, are attracted to Gulfstream’s offering at the very high end of the market. While China has only begun to develop as a significant market for business jets, Gulfstream has 50% market share there.

The recent introduction of the G650, Gulfstream’s new top-end jet, should produce high growth over the next 5+ years. The G650 has significantly raised the bar at the high-end of the market with improved speed, range, and comfort. The plane should drive market share gains for many years, since Bombardier’s response, the Global 7000/8000 is not scheduled to enter into service until 2017. Demand for the plane has been tremendous—the company currently has over 200 contracted G650s in backlog, which should fill Gulfstream’s delivery schedule for the next 5-7 years. Moreover, the backlog of Gulfstream’s other large cabin aircraft has remained quite healthy since the introduction of the G650 (~18-24 months, in line with historical levels). In the past, new model introductions have not cannibalized older model sales. For example, when the G550 began taking orders and making deliveries, sales of the G450 were not significantly impacted. Once production ramps, the G650 should earn significantly higher margins than Gulfstream’s other planes, leading to 25% or more average annual EBIT growth in the segment over the next five years (it should cost Gulfstream roughly the same to build a G650 as a G550, but the G650 sells for $15mm more).

It’s important to note that the company does not need a robust global business recovery to convert the contracted backlog of G650s into sales. A material number of Gulfstream large body order cancellations seems very unlikely, absent a collapse in the world economy.

The G650 has received provisional certification and is nearing the end of the FAA testing regime, which it should complete over the next few months. Because the FAA reviews performance data continuously throughout the testing, roadblocks are very unlikely in the latter stages of the process.

Defense

Defense spending will be pressured for the next several years. The Administration’s current defense budget proposal projects ~1.5% annual growth to the base budget from FY12 ($531bn) through FY17 ($567bn). (Note that GD does not generate significant revenues from the supplemental “OCO” war budget.) The defense savings which are heralded in headlines are “cuts” to the previous baseline assumption of more rapid growth. Under sequestration (the automatic cuts negotiated during the debt ceiling negotiations), the immediate impact would be an 11% decline in the FY13 base budget. However, the FY17 spending limit would be approximately $515bn, which is only 3% below the FY12 proposed budget of $531bn.

The cuts would likely fall disproportionally on weapons procurement, because it is difficult to curtail personnel and other costs in such a short period. We do not believe it likely that sequestration is implemented in January 2013—there is little political will for a budget which would materially impair U.S. military capabilities in the near term. Furthermore, current legislators cannot bind future congresses—defense spending over time will be dictated by the geopolitical environment, which shows few signs of becoming more placid. Additionally, U.S. forces have been engaged in hot wars for the last decade, in contrast to the post-Cold War “peace dividend” era. Whereas in the nineties the DoD could draw on a large surplus of new equipment, U.S. current capabilities have been depleted to a certain extent. Weapons procurement will certainly be pressured, but Pentagon officials are unlikely to implement drastic, across-the-board cuts.

In an environment of austerity, the Pentagon is likely to prioritize proven platforms, rather than ambitious, risky new projects. Politically, it is very difficult to terminate a long-running program, given how hard elected officials fight to protect the jobs base in their home state. Since GD is primarily exposed to mature, entrenched programs, we believe the company is relatively well-positioned versus competitors that have more new contract exposure.

Combat Systems (27% of CY11 revenue; 31% of CY11 EBIT)

GD’s Combat Systems group designs and produces tracked and wheeled military vehicles, weapons systems and munitions for the U.S. and its allies. GD’s largest Combat Systems programs are the following:

–   M1 Abrams: the main battle tank of the U.S. Army and Marines, and the armies of Egypt, Kuwait, Saudi Arabia, Australia, and Iraq.

–   Stryker: a family of 8-wheeled armored fighting vehicles used by the U.S. Army. The Stryker is used heavily in Afghanistan.

–   Light Armored Vehicles (LAV): similar to Strykers with a focus on reconnaissance and surveillance missions.

–   MRAP: “Mine Resistant Ambush Protected” light 4-wheel vehicles used heavily in Iraq as well as in Afghanistan. MRAP revenue is expected to be modest in 2012 and beyond. 

–   Armaments & Technical Products (GDATP):

• Gun Systems: heavy guns for ships, aircraft and infantry
• Weapons Systems: reactive armor for armored vehicles, hydra rockets and howitzer charges, and ammunition and materials handling systems for ships
• Advanced Materials: products made from composite materials, such as aircraft parts, missile launch tubes and specialized shelters and vehicle enclosures
• UAS Dynamics: small unmanned aircraft (UAVs)
• AxleTech: axles and parts for military vehicles

–   Ordnance & Tactical Systems: ammunition and artillery shells

–   European Land Systems: primarily LAVs for Spain and Austria, as well ammunition and other armored vehicles

Combat Systems is likely to be the worst performing division for GD over the next several years. Expenditure on both vehicles and munitions will decline as the wars in Iraq and Afghanistan wind down. However, a significant portion of the division’s revenue comes from maintaining and refurbishing existing vehicles. GD should also benefit from increasing international sales, especially to the Gulf States. Currently, 25% of the group’s sales are international.

In the latest budget, the Pentagon has not requested significant funding for the sustainment of the M1 Abrams or Stryker refurbishing and enhancement programs. The Pentagon had previously tried to shut down the M1 Abrams line, preferring to defer work until later in the decade. However, Congress has always allocated funding to keep it open. Especially in light of the upcoming elections, we believe it likely that Congress continues to maintain funding for the program, given that the unionized plant is in Lima, Ohio. Similarly, we believe that Congress will continue to fund improvements to the Stryker (primarily IED protection retrofits).

Marine Systems (20% of CY11 revenue; 17% of CY11 EBIT)

The Marine Systems group designs, builds and supports submarines and surface ships for the U.S. Navy and Jones Act ships for commercial customers. GD Marine Systems is one of two primary shipbuilders for the Navy, the second being Huntington Ingalls (recently spun out from Northrop Grumman). Marine Systems operates three primary shipyards:

–   Electric Boat: one of two shipyards that can build nuclear powered submarines. Currently building the Virginia Class Submarine, which is a nuclear-powered fast attack submarine (designed to sink other subs and ships, as well as launch conventional cruise missiles). They are currently doing design work for a next-generation ballistic missile submarine (designed to launch nuclear missiles).

–  Bath Iron Works: surface combat ships and service work. BIWs key program for the next several years will be the Arleigh Burk-class DDG-51 destroyer. The Navy generally splits orders between GD and Huntington Ingalls.

–   NASSCO: logistics ships for the Navy and Jones Act commercial ships. Based in San Diego, it is one of the only dockyards on the West Coast able to do heavy service work on Navy ships.

Marine Systems should be a steady performer for GD. Submarines have a defined operational life, and the Navy needs to build 2 submarines per year for the next several decades to avoid the depletion of the fleet. Destroyers are crucial to Obama’s missile defense strategy, and, similarly, the aging fleet needs to be replaced to maintain our capability. In its latest defense review, the Pentagon re-asserted its commitment to strengthening the Navy, especially in the Pacific, as a counterweight to a rising China.

Information Systems and Technology (IS&T) (34% of CY11 revenue; 30% of CY11 EBIT)

IS&T provides critical technologies, products and services that support a wide range of government and commercial communication and information sharing needs. The group consists of a three segments:

– Tactical communication systems: designs, manufactures and delivers trusted and secure communications systems, command-and-control systems and operational hardware. Key programs include the U.S. Army’s Warfighter Information Network-Tactical (WIN-T) and the Joint Tactical Radio System (JTRS).

– Information technology services: provides IT services to defense, and other government and commercial customers.

– Intelligence, surveillance and reconnaissance systems (IS&R): provides signals and information collection, processing and distribution systems; design, imagery solutions; and cyber security services and products. This segment works primarily with the intelligence community.

A top priority for the DoD is to improve information sharing throughout the military, what the Department calls “Network Centric Warfare.” As a result, communications programs such as WIN-T and JTRS are likely to be two of the very few areas of growth in Pentagon budgets over the next several years. The IT business helps the government and other customers save money in the long run. While projects could be deferred given a sometimes irrational budgeting process, we believe that the franchise will be secure over the long-term. It’s tough to get a good handle on many of the trends in IS&R, given that much of the work is classified. However, we believe that electronic intelligence will continue to be a priority for the intelligence community, especially given the increasing importance of cybersecurity. Note that approximately 40% of IS&T revenues are non-DoD related.

COMPETITION

GD’s defense programs are contracted through the DoD’s procurement process. Customer relationships, technical expertise, switching costs, manufacturing capabilities and established track record all combine to form formidable barriers to entry, especially in Marine and Combat Systems. Once a contractor wins a program, it almost always maintains that business over the life of the program. The industry has seen tremendous consolidation over time, and as a result, there are generally only one or two competitors with the capabilities needed to bid on new programs. While scale and knowledge of the defense procurement process are advantages for large defense IT companies such as GD, the IT services business is the most competitive of all of GD’s defense businesses.

MANAGEMENT AND CAPITAL ALLOCATION

GD’s management team is comprised of premier operators in the defense and private jet industries. The company has been able to sustain industry-leading margins throughout its business lines over many years. Management has historically deployed capital through a “balanced” approach of dividends, buybacks and acquisitions, and we believe that they are likely to continue with this strategy. Overall, the company has created significant value for shareholders through portfolio management—most notably selling off the majority of its business at high multiples in the early nineties, and buying numerous defense businesses later in the decade when expectations and valuations were very low. The company’s purchase of Gulfstream in 1999 and GM Defense in 2002 have both turned out very favorably for shareholders. Although the company’s last CEO, Nick Chabraja, did get caught up buying several businesses at high multiples during the booming defense environment of the last decade, we believe GD’s overall process is sound—this is a company focused on creating shareholder value, not empire building. Management incentives are aligned with shareholders. GD’s variable compensation is largely tied to earnings from continuing operations, free cash flow from operations, ROIC and EPS. Approximately 1/3 of senior management’s compensation is in cash while the other 2/3 is in stock. GD has stock ownership and retention guidelines that preclude corporate officers from selling shares until they own shares with a market value ranging from 8 to 15 times their base salary.

RISKS

- Sequestration causes a material decline in near term earnings.

- Loss of market share and/or margin pressure in the more competitive IT business.

- Management makes a low return acquisition.

- Unforeseen disaster with the G650.

SUMMARY

At 10x 2012 PE, we believe that GD is trading at a material discount to intrinsic value. With the likely growth in Gulfstream earnings and good capital allocation, we believe that the company will average high single digit annual EPS growth over the next five years, even while making conservative assumptions for the defense business. GD shareholders should benefit from a multiple rerating as the rapidly growing Gulfstream franchise represents a larger portion of the company’s earnings, and as uncertainty around future defense spending is eventually resolved. We believe an investment in GD is likely to generate attractive compound returns over the next five years with low risk of capital loss.

Catalyst

-  Faster growing Gulfstream business becomes a larger share of revenues and profits as G650 deliveries ramp up.

-  Overhang of sequestration / defense uncertainty eventually passes.