General Dynamics Advances, Shares Retreat

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After an initial, er, "surge" in response to Q3 earnings, shares of defense contractor General Dynamics (NYSE: GD) are today executing a phased withdrawal back to their pre-earnings positions. Why are investors beating a retreat?

I haven't a clue.

Military intelligence
I know this goes against the grain of Wall Street Wisdom, but a lot of defense contractors look like screaming "buys" right now, and to my ear, General Dynamics is screaming louder than most. Just look at the numbers it posted yesterday:

• Sales were up 4.5% to $7.1 billion.
• Earnings from continuing operations rose 19% -- that's four times as fast as sales -- to $1.59 per share.
• Free cash flow (year-to-date) currently eclipses last year's Q3 number by 28%.

So sure, General D didn't "make its number" on sales. Wall Street wanted to see $7.4 billion in revenues; the General showed up $300 million light. But I'll insist till I'm blue in the face: Making more profit than expected on fewer sales than expected is not a bad thing. Quite simply, it means the company earned fatter profit margins than anyone on Wall Street thought possible.

How fat?
Operating margins on earnings from continuing operations so far this year are clocking in at a fat 12.5% margin -- 140 basis points ahead of their tally by this point last year. If the General can keep this pace for the whole year, its operating margin is likely to be greater than what either Lockheed Martin (NYSE: LMT) or Raytheon (NYSE: RTN) earn, and means that General D would be closing the gap in profitability with the uber-profitable Textron (NYSE: TXT) and United Technologies (NYSE: UTX).

Nor are these profits some figment of the GAAP-drafters' imagination. General Dynamics backs up its "accounting earnings" with cold, hard, cash profits. At its present pace, the company is on track to generate some $2.7 billion in free cash flow this year -- a number that, if achieved, will have the stock selling for just 8 times free cash flow by year-end. For a company that analysts expect to grow 10% per year over the next five years, that's a bargain.

But will it? Grow, that is?
Yes. I'm certain of it. You see, General D grew its total backlog 30%, and funded backlog -- the company's most certain source of future revenues -- 35%. That's much faster than sales grew during the quarter, and it tells us that sales will almost certainly accelerate in the future.

Foolish takeaway
My advice: Buy General Dynamics now, while Wall Street is fretting over the "sales miss." Once its backlog starts transforming into profits, someone's bound to notice. Buy before they do.

Make the Fool your source for all things investing in general, and defense investing in particular. Read:

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