Heavy metal military specialist General Dynamics (NYSE:GD) reported Q2 earnings that largely fell short of expectations last week. Regardless, the military tank-builder's stock closed the week 2% higher than it began it. So what's up with that?
Q2 by the numbers
Last week, General Dynamics released its financial results for fiscal Q2 2016. For Q2, General Dynamics reported:
- Quarterly sales of $7.7 billion, down 3% year over year and about 4% short of analyst estimates.
- Operating profit margins up 30 basis points at 14%.
- As a result, operating profits that fell only 1% despite the much larger decline in sales.
- Moreover, profits actually grew 8% despite the sales decline, hitting $2.44 per share and beating estimates handily. This was largely due to stock buybacks that shrank the share count by 6%, concentrating fewer earnings among even fewer shares outstanding -- and growing earnings per share as a result.
Summarizing the results, General Dynamics downplayed the decline in sales. In fact, the company's always laconic prose recap of its quarter failed to mention the decline in sales at all. Instead, General Dynamics skipped merrily ahead to regale investors with tales of how expanding profit margins helped it to deliver "operating performance" (i.e., profits) that were nothing short of "record-setting" and in fact "unprecedented," as CEO Phebe Novakovic put it. Furthermore, management raised its guidance for the rest of this year, promising investors per share profits of anywhere from $9.20 to $9.70 by year end.
Will they get there? That's hard to say.
While management boasted that "three of the company's four business groups expand[ed their] margins over the year-ago period," it's also true that three of the company's businesses saw their sales decline in the quarter. Marine Systems sales fell 1%, Aerospace 6%, and Combat Systems 7%. Only the company's Information Systems and Technology group saw its sales increase, by about 1%.
It's also worth noting that IST earns General Dynamics' second weakest profit margin -- less than 11%, while the two GD three businesses that saw the biggest sales declines, Aerospace and Combat Systems, respectively, earn operating profit margins of 19% and 16%, respectively. Losing revenues in those businesses is going to hurt.
Granted, sales at General Dynamics' Marine Systems division, where sales fell only 1%, are expected to rebound quickly on a doubling of backlog due to the win of a big Navy fuel tanker contract. But that division actually earns the company's weakest profit margin of all -- just 9% last quarter. And in contrast to all the company's other divisions, Marine Systems was the only one to see a decline in operating margin last quarter.
The Foolish bottom line
General Dynamics management says it will earn at least $9.20 per share this year, and I take them at their word. That said, the way things are going, with high-margin businesses losing revenue and low margin revenues from shipbuilding taking their place, getting to $9.20 will be a struggle. It will probably require the company to buy back more shares, artificially boosting earnings per share to make up for weak profits overall.
And even if management succeeds in engineering this earnings feat, at today's share price north of $148, the stock sells for as much as 16.2 times projected earnings for the year -- or 15.2, if earnings hit management's hoped for mark of $9.70. Considering that analysts who follow the stock expect to see no more than 7% annualized earnings growth over the next five years, even mid-teens P/E ratios seem like too high a price to pay.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 309 out of more than 75,000 rated members.
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