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By all indications, the third quarter should have been a lousy one for General Dynamics (NYSE: GD ) .
Defense spending is on the wane, leading to lower sales and compressed profit margins. Plus, last month's durable goods report showed a simply shocking slide in orders for transportation equipment. For a change, this could not be blamed on Boeing (NYSE: BA ) (which had yours Fool-y, at least, speculating that it must be business jet orders that were diving.) If correct, this should have hurt General D's Gulfstream business, and its profits. The fact that Berkshire Hathaway (NYSE: BRK-A ) (BRK-B) announced earlier this month that it was eschewing wares manufactured by U.S. business jet makers Textron (NYSE: TXT ) , and Goldman Sachs (NYSE: GS ) subsidiary Hawker Beechcraft, preferring to buy from Brazil's Embraer (NYSE: ERJ ) , appeared to support this interpretation of events.
There was just one problem with my thesis ...
It was wrong.
Fly high, General D!
In fact, Aerospace proved General Dynamics' single best performing business in Q3, with revenues rising 15% from last year, and operating profits up 59%, boosted by a beefy 420 basis-point improvement in operating margin. These airborne gains more than offset weakness in the Combat Systems unit, such that, companywide, sales increased 4%, and net profits 16%.
Adding to the bullish mood, General D went on to predict that its full-year profits could reach $6.75 per share this year, ahead of analyst forecasts and about $0.10 higher than previously projected. Result: General Dynamics stock tacked on 2% in the midst of a truly miserable market performance yesterday, and is up another 2% today.
But is that the right call to make? I mean, sure, the news was good ... on the surface. Dig a little deeper, though, and this story gets a little more complicated. Backlog has dropped $4.4 billion from where it was at this time, last year, suggesting sales will slow going forward. Year-to-date free cash flow of $1.3 billion, while stronger than a year ago, still amounts to barely 71% of what General Dynamics claims for its GAAP "net earnings."
If the General keeps on as it's been going, free cash flow this year could run as low at $1.7 billion, leaving the General grounded at a 15 times FCF valuation -- a high price to pay for projected 7.5% long-term growth. My advice: General D had a great day yesterday, and you're richer for sticking with it to this point. But now, it's time to declare victory, collect your loot -- and go home.
Where are the best values in defense stocks today? Find out here.