General Dynamics Stock Pops Despite Revenue Decline, Weaker Net Earnings

The stock doesn't look all that cheap, either -- but could there be a wild card in General Dynamics' future?

Jul 23, 2014 at 4:22PM

On a wobbly day for the markets, with the Nasdaq up a fraction of a percent, but the Dow Jones Industrial Average down, one company is bucking the tide and showing bright "green": General Dynamics (NYSE:GD). Why is that?

File
General Dynamics didn't sell a lot of tanks this past quarter. So why do investors love the stock today? Photo: Wikimedia Commons.

Reporting earnings for its second quarter this morning, General D announced:

  • Revenue declined 5% to $7.5 billion, which was slightly short of estimates...
  • ...but operating profit margins gained 40 basis points in comparison to last year's second quarter.
  • Profits from continuing operations climbed 4% to $1.88 per share...
  • ...but after taking charges for discontinued operations, the company's bottom-line net profit contracted by 16%.

On the plus side, free cash flow for the quarter wasn't much affected by that noncash charge to earnings, coming in 46% better than reported net income at $791 million. Back on the minus side, General Dynamics management apparently warned investors during its earnings conference call that anticipated full-year revenue of $30.2 billion would fall short of analyst estimates. Operating profit margin is also seen slipping from second-quarter levels, averaging 12.5% over the course of the full year.

So on the face of it, this doesn't look like particularly great news. Revenue was down, and after you read between the lines a bit, it turns out that net profit also dropped. The full-year outlook also looks a bit cloudy, with profits possibly exceeding expectations (Benzinga reported that GD projects $7.40-$7.45 per share in full-year profit from continuing operations, which is ahead of estimates), but revenue showing continued slippage. So are investors right to be bidding up the stock today?

It depends on how far out you look.

Valuations matter. Timelines matter, too
In the near term, the valuation on General Dynamics stock does not look particularly good. Valued on trailing earnings ($2.3 billion, as calculated by S&P Capital IQ), the stock is trading for 17.9 times earnings today -- quite a high price for a projected 8% grower, even with the 2.1% dividend yield thrown in.

Free cash flow, which works out to $2.9 billion, results in a somewhat more attractive valuation of 14.2 times free cash flow. But that's still probably too much to pay for the stock's roughly 10% total return (dividends plus earnings growth).

The wild card, though, is the company's backlog. According to General Dynamics, total backlog of work to be done at the end of second-quarter 2014 was $71.1 billion. Add in $28.4 million worth of unfunded indefinite delivery, indefinite quantity contracts and unexercised options that management expects to transform into new orders over time, and the company's total potential backlog rises to $99.5 billion.

That's a roughly 29% increase over the $77.1 billion in total potential backlog GD reported in the second quarter of 2013. It suggests there's at least a chance that General Dynamics stock could surprise us and show earnings growth far in excess of the 8% rate projected by Wall Street analysts.

Turns out, the farther out you look, the better General Dynamics' stock starts to look.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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