Description

General Dynamics

I recommend a long position in GD (General Dynamics), whose Friday closing price is $212.77/share, mktcap=59B. General Dynamics is a global aerospace and defense company headquartered in Reston, VA. It's the 5th largest defense contractors ranked by market cap in the US (behind, RTX, HON, LMT NOC). For the past three years, its revenues were: 38.469B, 37.925B, 39.35B, and net incomes were: 3.257B, 3.167B, 3.484B (NetIncome/Revenue about 8.5%, return on tangible capital is about 11%); current P/E=18.1. The company's product include Gulfstream business jets, Virginia class and Columbia class nuclear powered submarines, Arleigh Burke class guided missile destroyers, M1 Abrams tanks and Stryker armored fighting vehicles.

GD has 10 business units, which are organized into four operating segments: aerospace, marine systems, combat systems and technologies; the later three collectively is the defense segment.

Aerospace

Revenue for the aerospace segment was 21% of the total revenue in 2021, 2020, and 25% in 2019. This segment consists of two wholly owned subsidiaries:

1): Gulfstream: which designs and manufactures its namesake business jets. Gulfstream was aquired in 1999 for 5.3B when GD decided to re-enter the civilian airplane business. The Gulfstream family of aircraft has industry leading cabin, cockpit and safety technologies, and the longest ranges at the fastest speeds in their respective classes. 

(2): Jet Aviation: Acquired by GD in 2008; Jet Aviation provides a comprehensive suite of innovative aircraft services for aircraft owners and operators around the world. It has about 50 locations throughout North America, Europe, the Middle East and the Asia Pacific region; services include maintenance, aircraft management, charter, staffing and fixed-base operator (FBO) services.

Marine Systems

GD's marine systems segment is the leading designer and builder of nuclear powered submarines and a leader in surface combatant and auxiliary ship design and construction for the US Navy. It also provides maintenance, modernization and lifecycle support services for Navy ships and maintain the most sophisticated marine engineering expertise in the world to support future capabilities. In addition to Navy ships, it also design and build ocean going Jones Act ships for commercial customers. As a percentage of total revenue, Marine Systems segment revenue was 27%, 26%, 23% for 2021, 2020, 2019.

Combat Systems

This segment is a manufacturer and integrator of land combat solutions worldwide, including wheeled and tracked combat vehicles, weapons systems and munitions. Segment revenue as a percentage of total revenue were 19% for 2021, 2020, and 18% for 2019.

Technologies

The technologies segment provides a full spectrum of services, technologies and products to an expanding market that increasingly seeks solutions combining leading edge electronic hardware with specialized software. Segment revenue as a percentage of total revenue were 33%, 34%, 34% for the past three years.

In terms of revenue source, in 2021, 70% of the consolidated revenue was from the US government (primarily DoD); 12% from US commercial customers; 10% from non-US government customers; 8% from non-US commercial customers.

                                          2021      2020      2019

DoD                                 21386   20840    19864

Non-DoD                          4862      4726      5254

FMS                                     598        737        689

Total US government     26846   26303    25807

% of total revenue             70%       69%       66%

US government revenue is derived from three types:

(1): Fixed-price: 57% of 2021 US government revenue. The contractor agrees to perform a specific scope of work for a fixed amount. Typically, the contractor assumes more risk when using fixed-price contracts; they also offer additional profits when the contractor complete the work for less than originally estimated.
(2): Cost-reimbursement: 36% of 2021 US government revenue. The customer reimburses contract costs incurred and pays a fixed, incentive or award based fee.

(3): Time-and-Materials: 7% of 2021 US government revenue. The customer pays a fixed hourly rate for direct labor and generally reimburses the cost of materials.

Let's note that companies in the defense industry, especially prime contractors, are essentially earning a regulated low rate of return about 10%. All R&D risk is borne by the government. Therefore, more than 70% of GD's revenue/profit is determined by government military budget.

Why GD is a good investment in the current environment.

 The defense industry is long cycled; and we are at the beginning of a long up cycle right now, which leads to multi-year earnings growth for GD's defense segment. House just voted to pass a massive defense policy bill a few days ago that would boost US total national security budget for 2023 to $850B. https://www.wsj.com/articles/house-to-vote-on-bill-boosting-defense-spending-with-inflation-help-for-troops-11657817584 Similarly in Japan and EU: https://www.wsj.com/articles/ukraine-war-boosts-support-for-added-defense-spending-in-japan-11657196729

https://www.reuters.com/business/aerospace-defense/germany-hike-defense-spending-scholz-says-further-policy-shift-2022-02-27/

Although not in the daily headline anymore, Ukraine war is still going on, and is just the beginning of the greater conflict between the west and Russia/China. The is a tragedy to the world but a boon to defense contractors.

GD's aerospace segment has limited exposure to the commercial airline industry. Gulfstream is the leader in the large cabin business jet market. The large cabin segment, which caters to the ultra rich, is significantly less cyclical than the low end of the market. Gulfstream also has a large and stable backlog and very low cancellation rate (order cancellation cost is very high due to milestone payment). Unlike commercial airlines, which have been decimated by the pandemic, private jet business actually benefited from the pandemic as wealthy customers want to stay away from other travelers for health safety concerns. The pandemic and numerous variants of covid-19 is likely here to stay for several more years... Also if someone is able to afford and got accustomed to flying private, he/she is unlikely to fly commercial again.

GD's business is very inflation resistant. It's a good "safe harbor" investment in the current environment.

Catalyst

Defense budget increase.

Russian/Ukraine war escalates to other parts of Europe.

Military conflicts in Taiwan and eastern asia.