Streetwise

Lauren Rudd

Sunday, June 5, 2011

How to Profit from Defense Spending

The sad truth is that global political instability, combined with a modicum of senseless idiocy, is unbridled evidence that mankind is not ready to beat swords into plowshares. Therefore, we will of necessity have to continue to maintain an outsized defense budget.

Even if it were possible to reduce defense spending to a more manageable level, ever watch what happens when a member of Congress sees his or her favored military procurement threatened? They become apoplectic.

One company answering the call to arms is General Dynamics (GD), a behemoth within the defense contracting world. A year ago I had projected GD’s 2010 earnings at $6.71 per share, with a 12-month target price on the shares of $74, for a potential capital gain back then of 15 percent. In addition, there was an indicated dividend yield of 2.6 percent.

So how did the company do? The shares recently closed at $74.22, and earnings came in at $6.82. Ok, so much for 2010, what is the prognosis going forward? Let’s begin by finding the intrinsic value using a discounted earnings model with an initial earnings number of $2.6 billion and a discount rate of 10 percent.

If you let earnings grow at the 5-year consensus rate of 9 percent for each of the first 10 years and 5 percent for subsequent years, the result is an intrinsic value of $173 per share.

A more conservative discounted earnings model that uses a 15 percent discount rate but allows earnings to grow at 6 percent after 10 years produces an intrinsic value of $121. Therefore, the shares are trading at either a 42 percent or a 61 percent discount to their discounted earnings intrinsic value.

The intrinsic value of the shares using an even more conservative free cash flow to the firm methodology is $144, a number that has the shares trading at a 51 percent discount to their intrinsic value.

Dividends are a key factor in any stock evaluation, and GD has increased dividends in nine of the last eleven years. During the past five years dividends have increased from $1.12 to $1.64 per share. Furthermore, GD has a dividend payout ratio of 24 percent, meaning that the amount paid in dividends is 24 percent of earnings. It also means that there is still considerable room for additional dividend increases.

GD has a 17 percent long-term debt/equity ratio and a total debt/equity ratio of 23 percent. In this instance, a debt/equity ratio below 50 percent would be considered more than acceptable.

The company is also no secret with regard to institutional investors. Approximately 1,138 own 81 percent of GD's outstanding shares. So what does that mean to you? When a large number of institutional owners (80 or more) hold 50 percent or more of the outstanding shares, it is a major milestone towards being called a blue chip company.

The company has 372 million shares outstanding, well above the 50 million share mark that I would consider to be a minimum for sufficient trading liquidity.

Digging into 2010 growth numbers, revenues were up 3.33 percent, net income grew at a rate of 10.16 percent, while cash flow was up 7.96 percent. Over the trailing 12 months, the company's price-to-sales ratio was 0.88, which means you are buying GD's revenue at a discount.

Now let’s look at 2011. For the first quarter GD reported earnings from continuing operations of $1.64 per share, as compared to $1.54 per share for the same period a year ago. Revenues for the quarter were $7.8 billion, with net earnings posted at $618 million, as compared to $597 million a year ago.

The company's first quarter operating margin was 11.9 percent, compared to 11.8 percent in 2010. Funded backlog at the end of first-quarter was $43.9 billion, while total backlog was $57.6 billion.

Net cash from operating activities in the quarter totaled $327 million. Free cash flow from operations, defined as net cash from operating activities less capital expenditures, was $266 million.