By now you've heard the news. General Dynamics (NYSE:GD), maker of tanks, builder of warships, owner of the Gulfstream line of luxury business jets, "missed" its sales numbers last quarter. General Dynamics stock sold off mildly on the news, and closed the week down 0.7% from its pre-earnings price. Clearly, investors were not pleased with the news.
But could they be missing the point?
For its fiscal third quarter 2016, General Dynamics reported the following headline numbers:
- Sales declined 3.3% to $7.7 billion.
- Net profit on those sales fell 6.8% to $683 million.
- But the share count also declined, such that profit was divided among fewer shares, with the result that profit per diluted share slipped only 3.1% to $2.21.
So not a great start, but now here's the part that really seems to have spooked investors: As General Dynamics transitions from selling G450 and G500 business jets, to selling more advanced G550 and G600 business jets, it's selling fewer of the former -- and not enough of the latter. One year ago, in Q3 2015, General Dynamics delivered 43 Gulfstreams of various models to its customers. This year, Q3 saw only 27 Gulfstreams delivered, with General Dynamics' aerospace revenue falling 14% as a consequence. What's more, the broad shift to newer jet models may not be General Dynamics' only problem.
Reuters reports that demand for business jets is "weak" across the industry today. Textron (NYSE:TXT) apparently characterized demand for its own Cessna brand of business jets as "stubbornly soft" last week. Now General Dynamics is suffering from the same problem afflicting Textron -- and the model transition is only adding to its troubles.
Keep your eye on the ball
But here's the thing: Business jet purchases may broadly track the economic cycle, with companies spending on jets when business is brisk, and tightening their purse strings when worries over the economy mount. Despite weakness in its most profitable business segment, however, General Dynamics managed to post stellar operating profit margin on its jets last quarter (21.7% in aerospace), and very strong margin in its overall business (13.8%) as well.
Assuming the company can maintain those kinds of profit margins when the market for business perks up, the company's profits could really roar on higher revenue. Meanwhile, margins remain strong in the company's healthier business lines, and in fact improved 90 basis points overall year over year. That lends an investor confidence that General Dynamics will remain soundly profitable while it awaits a revival in demand for its most profitable product.
The upshot for investors
So given all this, you must assume I think General Dynamics stock is a buy, right? Well, actually, no. I cannot recommend General Dynamics stock at this time, and for the simple fact that the stock costs too much. While General Dynamics' strong profit margin has resulted in admirable trailing net profits of $2.9 billion, actual free cash flow for the past 12 months was barely one-third of that number -- $1.1 billion.
S&P Global Market Intelligence data currently pegs General Dynamics' market capitalization at $46.1 billion, which, when divided by the free cash flow number, results in a price-to-free-cash-flow ratio of 41.9. (The company also sports a modest debt load, resulting in a debt-adjusted P/FCF ratio that's even more expensive.) With most analysts still predicting only 6% long-term earnings growth at the company, I don't see any good reason for General Dynamics stock to be selling for such a high multiple.
In short, Gulfstream may be the reason other investors avoided General Dynamics stock last month. For me, it's the stock's valuation that counsels against taking a flyer on this one.
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. 333 out of more than 75,000 rated members.
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