Three weeks ago, we started reviewing defense-industry stalwart General Dynamics (NYSE: GD), then we dropped off for a few weeks so I could have a conniption or two. We're back on the subject now, though I reserve the right to throw another tantrum grande at a moment's notice.
Let's clean up some other unfinished business first. Last week, we discussed whether we should sell Schering-Plough (NYSE: SGP). We would base this decision on several factors, such as its apparent violation of Regulation Fair Disclosure and its management's generally negative treatment of its owners. I was taken to task on some message boards for not following a simple rule that we have stated many times: "SEC investigation = sell." And rightly so.
This company regularly refuses to answer investor questions, has incurred the wrath of the Food and Drug Administration in the form of a $500 million fine over bad manufacturing habits, and followed up meetings with analysts with a press release and heavy-handed explanations.
But the automatic sell rule is supposed to protect one from grievous loss, not respond to loss that has already occurred. In this case, it came too late. Despite my distaste, I'm not ready to sell our shares just yet -- it is simply too cheap. If its board members didn't have to shake their heads to generate enough friction to come up with a thought, they would throw out Richard Kogan and start anew -- current management's actions over the last year have destroyed their credibility with investors. As a result, the stock should now have a tax on it -- call it a "bozo discount."
But, as far as I can tell, its current price represents a worst-case scenario valuation -- even if I wanted to sell, I'm too late. My instinct, though, is to keep a bias toward selling this company as soon as the stock price becomes more optimistic.
Why General Dynamics?
As we described in the first article, General Dynamics is one of the oligarchs of the defense industry, one of only a few massive companies that provide big-ticket pieces of military hardware to the U.S. military and Allied forces. It also offers a significant revenue base from its Gulfstream aerospace division, which adds up to about 24% of total revenues for the company. Thus far this year, it has grown its top line by 13.3% from $8.7 billion for the first nine months of 2001 to $9.9 billion for 2002. Earnings per share over the same period also increased by 13.3%.
It is particularly interesting, as noted in the company's most recent quarterly report, that its widely predicted weakness in aerospace and shipping did not come to pass. Over the last five years, General Dynamics shares have increased in value by more than 150%, while the S&P 500 has only grown a total of 29%, and the value of shares of its defense peers as a whole actually has decreased 3%.
Despite this strong share performance, the stock trades at a discount to both its peer group and the S&P 500. Of course, none of that means much if the company is priced above intrinsic value, or if it fails to provide economic returns on capital for shareholders.
I don't necessarily think General Dynamics is screamingly cheap, even though it does trade at a discount. Sometimes one should be willing to pay up for quality, and the defense contractor has it in spades. The company is managed to maximize free cash flow and returns on invested capital, provides no guidance to analysts, and keeps a pristine balance sheet with decreasing debt. Its management team is headed by low-profile CEO Nicholas Chabraja, who shuns the limelight and tends to let results speak for themselves.
Even with a paucity of debt, it has averaged a return on equity of 16.9% over the last five years (17.8% in 2002), annual revenue growth of 28%, and free cash flow growth of 17%. Over the last five years, it has generated free cash flow of $3.1 billion. Assuming continued positive economic performance, Chabraja has set a goal of eliminating General Dynamics' net debt in its entirety by 2004.
Moreover, one of the great things about economics in the defense industry is that sales are known well in advance. As of the most recent quarterly earnings announcement, General Dynamics had an order backlog of more than $29 billion, of which $21.5 billion was "funded," which means the government entity or company making the order had financial appropriations committed to filling the order. Moreover, even for projects with extremely long tails, such as multiple ship orders, it is extremely rare for a government to default on a contract.
They build cool stuff
You know you're dealing with a company that doesn't play around when the description of one of its new products is "improved lethality." I am not making this up. You know the same when the CEO, in describing company activities, uses such terms as "classified satellite payloads." That's one of the realities of investing in a defense company -- it will be involved in certain activities about which you will never, ever hear.
From an investment perspective, there are pros and cons in the long-lead economics that dictate General Dynamics' business. On the one hand, it is highly predictable. As it stands, the $29 billion backlog means guaranteed business over the next few years. It is unlikely it will suddenly find its factories idle. By the same token, such sales have already been factored into its share price.
Military spending, particularly on heavy machinery, is planned years in advance, sometimes as much as a decade. As such, investors should keep in mind that there's very little information among companies like General Dynamics that isn't already widely known in the investment community.
This means that an investment in the company must be slightly opportunistic -- its share price is not likely to become completely disjointed with its economic prospects. However, the general tendency of stock market participants toward short-term thinking means that even the most staid companies occasionally come at discounts.
I think the short-term focus is on perceived weakness both at Gulfstream and the marine division, and also on questions about potential litigation from the U.S. Navy over the cancellation of the $1 billion A-12 attack jet program in 1991. Well, the dispute with the Navy will work itself out regardless (even though the company would have to pay a hefty sum if it loses). And, as the most recent quarter has shown, neither Gulfstream nor the marine division performed as poorly as expected -- and with the launch of three additional jet models, General Dynamics expects Gulfstream to be even more competitive in the $10 million-$45 million private-jet market.
So, my earlier conniption fits notwithstanding, we're buying shares of General Dynamics in the next five business days.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann is a proud member of the Ardbeg Committee. He is also the managing editor of The Motley Fool Select, where you can find his best Foolish stock ideas that you won't find anywhere else. The Motley Fool has a disclosure policy.
The Rule Maker Portfolio has had a cumulative investment of $43,000. As of Oct. 22, 2002, its current value of all cash and equities is $29,770.05. This equals an internal rate of return of �12.3% since the launch of the portfolio in February 1998.
