Defense contractor General Dynamics (NYSE:GD) generally impressed investors with its earnings report last week. Sure, sales fell 3% year over year, and fell short of analyst estimates as well. But with improving profit margins and a shrinking share count, the company managed to turn investors' frowns upside down -- and turn lower revenues into higher profits.
Earnings for the fiscal second quarter grew 8% to $2.44 per share, several cents better than expected. And that's not all: General Dynamics followed up its earnings beat with a raise in guidance for the rest of this year. Encouraged by its strong performance so far, management now says it should be able to earn $9.70 per share by year-end.
But how did the company come up with that number? General Dynamics has developed a reputation for short, to-the-point earnings releases, heavy on numbers but light on commentary describing where those numbers came from. In its post-earnings conference call last week, though, management shed some light on how it came up with the numbers for its latest earnings guidance.
Let's take a look.
1. Gulfstream flying lower, but stronger
For Aerospace, our [previous] guidance was to expect revenue somewhat lower than 2015 and margins somewhat higher than 2015, leading to flat operating earnings. We now expect to be between $8.5 billion and $8.6 billion of revenue, with margins slightly above 20%. This implies a slight pressure on margins in the second half, particularly in the third quarter. This will result in operating earnings the same as last year or even slightly better.
-- CEO Phebe Novakovic
Assuming General Dynamics hits the top range of that guidance, the company's Aerospace revenue, which comes primarily from sales of its Gulfstream line of business jets, will decline about 3% from last year, but be roughly equal the revenue booked in 2014.
The better news here is that "above 20%" operating profit margins will be significantly better than what General Dynamics achieved in either 2015 or 2014 -- at least a 150-basis-point improvement over two years' time. This implies that the Aerospace segment should contribute about $1.7 billion in operating profit to General Dynamics' overall haul for the year.
2. Thanks for tanks
For Combat Systems, our previous guidance was to expect revenue of approximately $5.8 billion, and margins in the mid-15% area. We now expect revenue of somewhat over $5.7 billion, and margins at 16% to 16.1%. Revenue will see strong uplift in the fourth quarter. The difference in revenue guidance is simply from timing.
Revenue of $5.7 billion from General Dynamics' tanks and armored personnel carriers business is less than the company previously expected to report. Still, if achieved, it will represent a small 1% gain in sales versus 2015, and be about on par with the revenue this segment recorded in 2014. Mid-15% margins (say, 15.5%) would be about the same profit margin achieved in 2015, better than reported in 2014, and probably contribute profits of about $890 million to the company's total for the year.
3. Send in the Marines!
For the Marine group, we previously guided to revenue of $8 billion and margins in the mid-9% range. We now expect revenue to be between $8.1 billion and $8.2 billion, and margins around 9.2%.
Finally, some good news on revenue! With a little help from the U.S. Navy and a big contract to build TAO(X) oil tankers for its fleet, General Dynamics looks ready to begin growing revenue in its Marine Systems group. And whether the final revenue number for the year clocks in at $8.2 billion or only $8.1 billion, it now looks certain that for the fourth straight year, General Dynamics will grow its revenue in this segment.
Now, would it be nice to see revenue "in the mid-9% range," instead of at 9.2%? Sure it would. Still, 9.2% margins on even $8.1 billion in revenue would contribute $745 million to General Dynamics' operating profits.
4. Information Systems and Technology and more good news
For IS&T, we guided to revenue of about $9 billion and margins approaching double-digits. It now appears that our revenue guidance was good, with slight upward pressure, and that operating margins would be somewhat better than 10.5% for the year.
And ending on a high note, General Dynamics says both revenue and margins are turning out better than expected at its IS&T division. $9 billion in revenues should be roughly equal with what the IS&T unit turned in last year, and with margins inching up to 10.5%, operating profits should come in at roughly $945 million.
5. Pulling it all together
All of this rolls up into revenue for GD of about $31.5 billion, operating margins of 13.7% to 13.8%, net income somewhat more than the $3 billion, and a return on sales of around 9.6%. Compared to our initial guidance, we will have somewhat lower revenue, but higher operating income on higher margins, a somewhat lower tax rate and a lower share count, which permits us to increase our EPS guidance to $9.70.
When all's said and done, General Dynamics thus looks on track to hold revenue more or less steady against last year's level, add as much as 50 basis points to companywide profitability, and thereby grow operating profits by perhaps 4%. With the benefit of a smaller share count, that all adds up to respectable 7% growth in earnings per share.
With half the year already in the bag and less than six months to go, it looks like the company is on track to meet its target for 7% earnings growth. Whether such a growth rate is fast enough to justify paying nearly 16 times earnings for the stock today, though, is a decision only you can make.
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. 308 out of more than 75,000 rated members.
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