General Dynamics Stock Gets Promoted

Perhaps appropriately for an arms merchant, General Dynamics (NYSE: GD  ) stock is exploding this week, up nearly 8.8% since reporting earnings Wednesday morning -- and up about twice as much as the gains o fellow defense contractor Boeing (NYSE: BA  ) , which also reported Wednesday.

What's behind General D's surprising strength? In its famously pithy style, the General laid out its results in a press release just 15 sentences long (plus a few tables). Now here's an even more condensed summary of the results:

  • Revenues for the first quarter of 2013 declined 2%, reflecting some impact from the Sequester.
  • However, operating profit margins grew a modest 10 basis points, mitigating the slowdown.
  • Interest payments on debts and tax payments to the feds both shrank, helping further.
  • Result: Net profits actually grew a bit, and when combined with the beneficial effect of share buybacks, General D emerged from the quarter with a small gain to earnings per share -- $1.62, up 3% from last year.

So all in all, not a half bad performance in a quarter when defense contractors were supposed to be hurting from a sudden slowdown in Pentagon spending. But are these numbers good enough to justify a more than $2 billion increase in GD's market cap?

Possibly. In addition to all the good news on the "GAAP" front, General Dynamics also executed where it really counts, increasing the amount of free cash flow that its business churned out by a staggering 32% -- to $429 million. As a result, General Dynamics stock now carries less than an 11-times free cash flow valuation, which looks entirely appropriate in light of its projected 7.1% profits growth rate, and generous 3.3% dividend yield.

The big risk here, of course -- and the single biggest risk to General Dynamics' stock price -- is the risk of a slowdown in defense spending. You see, General D's funded backlog number has dropped to $42.4 billion post-sequester. On the one hand, that's enough work to keep GD busy building tanks, missiles, and warships for at least the next 16 straight months. On the other hand, the number's moving in the wrong direction, and is down more than 8% in comparison to this time, last year.

All this suggests that the well of work GD draws from, if not exactly dry, is starting to dry up. This suggests that the growth rate this stock's valuation depends upon -- 7% -- is a rate that wasn't all that strong to begin with, and could weaken even further. 

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