Nikhith Naidu
UG SMF 2012-2013
Final Analyst Report
Company Overview
General Dynamics is a diversified company that generates most of its revenues from
defense contracting but also sells to US Commercial enterprises. General Dynamics
faces significant competition in these markets from companies such as Northrop
Grumman, Lockheed Martin, Boeing, Rockwell Collins and BAE Systems. As a
consequence of the competition, it is not uncommon for General Dynamics to try to stay
relevant to its industry by investing heavily in R&D, working closely with its competitors
and making numerous acquisitions. In 2011 alone, General Dynamics acquired 6
companies in order to complement and grow its existing businesses. The company is
split into four divisions, aerospace, combat systems, marine systems, and information
systems and technology. Each of these divisions operates with a significant level of
autonomy.
General Dynamics’ aerospace division has the highest growth out of the four divisions
and represented 19% of the company’s total sales in 2011. It primarily consists of the
business jet brand Gulfstream, and has 5 product lines ranging from mid to large size.
This division is a leader in the business jet market and has $6 billion in sales
representing a 13% growth between 2010 and 2011. General Dynamics is investing in
the growth of this division by implementing a $500 million seven year expansion
program. In addition, it has made an acquisition of Jet Aviation, a maintenance and
services provider, in an attempt to gain further traction in the aftersales market.
Currently, about a quarter of this division’s sales come from its aftermarket services.
General Dynamics’ combat systems division manufactures and designs tanks, combat
vehicles, ammunitions, propellant and other goods that are used in ground combat.
This division saw strong growth over much of the past decade as a result of the US
involvements in Iraq and Afghanistan; however as the US moves out of those areas,
this division can anticipate a significant decline in the demand for its products. This
division is a leader in the industry and its proven success has attracted international
customers. In an effort to appeal to international governments, General Dynamics has
expanded to include manufacturing plants in many nations in Europe. However, these
moves have only partially offset the decline in demand from the US, and as a result,
revenues in this division have fallen by 8% over the past 2 years. Combat systems had
sales of $8.8 billion in 2011 and represents 27% of General Dynamics’ total sales.
General Dynamics’ marine systems division is one of the two primary shipbuilders for
the US Navy.
This division notably includes Electric Boat, and designs and
manufactures Virginia-class nuclear submarines, battleships, combat logistics ships,
and a small number of commercial ships. This division makes nearly all of its sales to
the US Navy and has steady contracts that extend to 2018. It produces the only
submarine designed specifically for post-Cold war combat. In addition, this division
anticipates aftermarket repairs and services that will extend to 40 years after contract
delivery. Revenues for this division were $6.6 billion, representing 20% of the General
Dynamics’ total sales.
General Dynamics’ information systems division provides technological services in three
main areas: tactical communications systems, information technology services and
intelligence, surveillance and reconnaissance systems. General Dynamics largely
provides these services to the US military; however, it also does work with the UK
Ministry of Defense, the Canadian Department of National Defense, as well as public
and private groups in Europe and the Middle East. Its information technology services
business is not entirely exposed to military enterprises, but instead provides services to
all aspects of the government. Specifically, General Dynamics supports military health
divisions as well as Medicare and Medicaid. General Dynamics is supporting the
government through the healthcare reform. Revenues for this division were $11.2
billion representing 34% of General Dynamics’ total sales.
Revenue By Segment
Information
Systems, 34%
Aerospace, 19%
Combat Systems,
27%
Marine Systems,
20%
Business Analysis
General Dynamics saw strong growth over the past decade as defense spending
increased substantially in light of national security threats and US involvement in Iraq
and Afghanistan. However, since US defense spending is expected to decline in the
coming years, General Dynamics will have to look elsewhere for most of its growth and
sales.
General Dynamics’ aerospace division has strong potential for growth. Specifically,
since the company has invested in expanding this division and has made acquisitions of
companies that have strong aftermarket presence, General Dynamics is poised to
capture a greater market share of the business jet market. In addition, the business jet
market is almost entirely commercial and is expected to see slight growth in the
upcoming years. General Dynamics has a diversified product line that can cater to all
price levels of the business jet market and has seen growth in this division in the past.
Overall, this division is the company’s best outlook for growth.
Conversely, General Dynamic’s combat systems division is the company’s worst
outlook for growth. Specifically the majority of the sales of this division go to the US
Government, and this division’s products were used mostly in combat in in the Middle
East. As the US is withdrawing its forces from Iraq and Afghanistan, demand for the
company’s products is falling steeply. As a result this division faces significant negative
growth outlook for the foreseeable future.
General Dynamic’s marine systems and information systems divisions will be relatively
unaffected by the US withdrawal from Afghanistan and Iraq. However, both divisions
will face a decline in demand from the US government as a result of austerity measures.
Specifically, the upcoming fiscal cliff will likely result in a cut in defense spending which
in turn will result in fewer contracts for General Dynamics and therefore a decline in
sales. While the information systems is positioned to take advantage of the changes
that will need to be put in place as a result of the Affordable Care Act, it will still face a
decline in demand of its services from its largest customer, the Department of Defense.
The marine systems division almost exclusively works with the US Navy and is not well
positioned for commercial markets, so it will see its sales decline.
Business Risks
The biggest and most impactful risk facing General Dynamics is the coming decline in
defense spending by the US Government as a result of austerity measures. With the
recent election of a highly divided house and the upcoming fiscal cliff, the outlook for
government defense spending looks bleak. The US Government is the largest
consumer of General Dynamics’ products, representing 69% of General Dynamics’
sales, so the upcoming sequestration of the government’s budget puts General
Dynamic in a poor position for growth. If a compromise is reached on the budget, it will
likely include higher spending across the board and be beneficial for General Dynamics;
however with the divided house, there is a major risk that no compromise will be
reached and that US Government spending will see a sharp decline.
The next largest risk comes from General Dynamics’ competition. Specifically, General
Dynamics will have to constantly produce cutting edge products that can outperform
similar products provided by its competitors. In addition, General Dynamics will have to
constantly acquire companies in order to grow and add new technologies to its portfolio.
While US Government contracts are often for development and manufacture of
products, foreign and commercial sales often purchase products after development.
For these customers, who represent an increasing portion of General Dynamic’s sales,
the company will have to front the development costs. If these products are not able to
compete effectively in the marketplace, then General Dynamics will lose much of its
developments costs and be in poor position for future sales.
General Dynamics also faces some degree of contract risk. Many of its contracts are
fixed price contracts meaning that it will be paid some amount by the customer under
the expectation that General Dynamics will be able to develop and deliver a product by
a certain date. While these contracts provide great predictability of cash flows and
revenues as well as safety due to their long term nature, they do pose one risk. In the
process of development, General Dynamics might fall behind schedule and face
penalties, or spend more than the fixed price of the contract and therefore lose money
on the deal. While General Dynamics has been successful in the past at meeting cost
and timeline expectations, there is no guarantee that they will be able to continue this
performance.
Key Financial Data and Ratios
Year
Revenue (USD
Mil)
Operating
Margin
Return on
Assets (%)
Return on Equity
(%)
Return on
Invested Capital
(%)
Debt/Equity
Free Cash Flow
(USD Mil)
Free Cash Flow
Per Share (USD)
2004
19,178
2005
21,244
2006
24,063
2007
27,240
2008
29,300
2009
31,981
2010
32,466
2011
32,677
10.12
10.34
10.91
11.43
12.47
11.49
12.15
11.71
7.28
7.87
8.85
8.61
9.09
8.05
8.25
7.49
18.72
19.06
20.65
19.19
22.54
21.3
20.39
19.03
12
13.33
15.44
15.25
17.17
15.77
16
15
0.46
1,536
0.34
1,777
0.28
1,794
0.18
2,451
0.31
2,620
0.25
2,455
0.18
2,614
0.3
2,780
3.81
4.39
4.41
6.01
6.57
6.33
6.79
7.46
Valuation
Currently, General Dynamic’s free cash flow is $7.46 per share. The share price is
around $63. This means that the company has a very strong free cash flow yield of
11.8% per share. However, the growth outlook for the company is not as strong. To
determine growth, we will perform a segment breakdown of the company.
We anticipate strong growth in the aerospace division. Specifically, we anticipate that
the growth that we have seen from 2010 to 2011 will continue as General Dynamics
invests significantly in this business line. We will assume that the annual growth for this
segment will be 8%.
The combat systems division will be hit the hardest by the change in defense spending.
Specifically, as combat forces are withdrawn from Iraq and Afghanistan, we anticipate
that the demand for this division’s products will decline significantly. Over the past two
years, this division saw a decrease in sales of about 8%. We anticipate that this decline
will steepen as the US moves to complete its withdrawal and the Department of
Defense faces budget cuts. We anticipate an annual growth rate in this division of -9%.
The marine systems division almost exclusively serves the US Navy and will therefore
see the same 10% budget cut that the US navy will see under sequestration. It is
possible that fiscal cliff will be avoided and that there will be a less than 10% cut in
spending; however for this purposes of this valuation we will be conservative in our
estimates. We do not anticipate any long term shift in the demand structure for this
division.
The information systems division will see growth as a result of the Affordable Care Act;
however it will also be adversely affected by the decline in the Department of Defense’s
budget. Overall we estimate that the growth rate for this division will be 3% with a onetime 10% cut as a result of sequestration.
After aggregating all of these estimated growth rates, we estimate that the growth rate
for the company will be very small, less than 1%, but not negative. In addition, we
foresee an 8% drop in free cash flow as a result of the company’s exposure to fiscal
cliff. Therefore, we anticipate a long term free cash flow yield of 10.8% with a negligible
growth rate.
Summary
General Dynamics is a diversified company that has been a leader in the aerospace
and defense industries. We believe that it will continue to be a leader in this industries
and that it will expand its business to attract more commercial and foreign customers.
We believe that General Dynamics’ strong free cash flow yield makes it an excellent
buy.
Appendix
Stock Price
Income Statement
Balance Sheet
Cash Flow Statement