Streetwise

Lauren Rudd

Sunday, June 3, 2012

Defense Industry Remains Viable

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 a disproportionately high defense budget.

At the same time it is not unreasonable to expect Congress to rein in defense expenditures that will not endanger our country’s security or decrease the effectiveness of our fighting forces. All of which points to continued investment opportunities within the defense industry.

Consider for example General Dynamics (GD), a behemoth within the defense contracting world. A year ago I had projected earnings for 2011 of $7.43 per share with a projected 12-month share price of $84. At the time the shares were trading at $74.22 and there was an indicated dividend yield of 2.60 percent.

So how did the company do? The shares recently closed at $64.35, and earnings came in at $7.28, which after dividends is a 10.30 percent decline in capital value. Yes, the often used reason is concern over reduced defense procurements given the decline of military operations in Iraq in 2011, followed by the continuing redeployment out of Afghanistan.

Ok, so much for 2011, now what is the prognosis going forward? It is obvious that as disdainful as it might be, we are going to have to accept increases in military expenditures although they will undoubtedly be oriented towards the utilization of ever more sophisticated and expensive technology.

This portends increased earnings and a higher share price for General Dynamics. To that end, the company will focus on the revival of the business jet market through its Gulfstream division, along with military programs such as the Warfighter Information Network Tactical (WIN-T) program and Joint Tactical Radio System.

Similarly, the company should receive a boost from higher volumes in its military vehicle business (Stryker combat vehicles and Abrams tanks), along with ship programs such as the Arleigh Burke (DDG-51) class destroyers, Virginia class submarines and the Mobile Landing Platform program.

General Dynamics has one of the strongest balance sheets among its peers with a low long-term debt-to-capitalization of 20.5 percent at the end of the first quarter of 2012. The company’s free cash flow from operations, defined as net cash provided by operating activities less capital expenditures, reached $2.8 billion in fiscal 2011.

In the first quarter of 2012 cash provided by operating activities was $414 million. Free cash flow from operations was $324 million in the first-quarter. For comparison during the first quarter of 2011 net cash provided by operating activities was $328 million, and free cash flow from operations was $267 million.

More importantly, the intrinsic value using a discounted earnings model with initial earnings of $2.5 billion and a discount rate of 15 percent and an earnings growth rate of 7.7 percent for each of the first 10 years and 6 percent for subsequent years is $103 per share.

The intrinsic value of the shares using an even more conservative free cash flow to the firm methodology with a growth rate of only 5 percent is $138, a number that has the shares trading at a 46 percent discount to their intrinsic value.

Dividends are a key factor in any stock evaluation, and General Dynamics has increased dividends in ten of the last twelve years. During the past five years dividends have increased from $1.34 to $2.04 per share. Furthermore, the Company has a dividend payout ratio of 28 percent, meaning that there is room for additional dividend increases.

Total debt-to-equity ratio for the most recent quarter is 28.21 percent, where as any debt-to-equity ratio below 50 percent would be considered more than acceptable.