General Dynamics Strikes a Deal in Peru

Boasting more than 50 main battle tanks and more than 600 armored personnel carriers (APCs), Peru's army looks like a pretty fearsome fighting force -- on paper. In fact, it's more of a paper tiger.

Peru's army on parade. Image source: Galeria del Ministerio de Defensa de Peru. 

The vast majority of Peru's tanks are old Soviet T-55s, first designed in the 1950s, while most of its APCs are American and German relics dating from the 1960s. And while the country at one point had plans to purchase a fleet of modern main battle tanks from China, those plans fell through a few years ago, when Peru was unable to come up with the needed cash -- all of which leaves its ground army in a pretty sorry state.

But fear not. General Dynamics (GD -0.29%) is about to ride to Peru's rescue.

Stryking a deal

Last week, in something of a surprising development, the U.S. Defense Security Cooperation Agency revealed to Congress that the Peruvian government is seeking to purchase a whole fleet of modern armored personnel carriers from General Dynamics. Specifically, Peru seeks to acquire 178 reconditioned Strykers, each equipped with a .50 Cal M2 machine gun and a Remote Weapon Station to operate it.

General Dynamics will act as the prime contractor on the sale, which will be worth $668 million.

DATA SOURCE: YAHOO! FINANCE.

What it means to Peru

While a less robust weapons platform than the Chinese tanks that Peru was eyeing a few years ago, General Dynamics' Strykers also cost significantly less -- just $3.5 million per unit, or about 60% of what China wanted for its tanks. Even so, there's a real question whether Peru will be able to afford the purchase. Current U.S. plans call for less than $1 million in annual foreign military aid for Peru, which means that the country must pay for these Strykers out of pocket.

That said, if the sale does go through as planned, here's what it means for General Dynamics.

What it means to General Dynamics

General Dynamics is a company probably best known for its armored vehicles -- primarily Abrams main battle tanks and Stryker APCs. What you may be surprised to learn, though, is that such ground "combat systems" are actually General Dynamics' smallest business division. According to data from S&P Global Market Intelligence, General Dynamics actually gets more revenue from its civilian Gulfstream business jet business, from the construction of submarines and surface warfare vessels for the Navy, and even from information technology sales, than it does from selling Strykers and Abrams(es).

That being said, Combat Systems is no slouch in the profits department, generating 15.6% operating profit margins for General Dynamics on each dollar of sales. This implies that investors can expect General Dynamics to reap as much as $104.5 billion in profits on the sale of $668 million worth of Strykers to Peru, or about $0.34 per share.

Should you buy General Dynamics stock?

Based on these numbers, it seems the Peruvian Stryker sale will add roughly 2.2% to General Dynamics' $30.9 billion annual revenue stream, and about 3.6% to annual profits. It's an above-averagely profitable deal for General D. But is it reason enough to buy the stock?

Probably not. To know whether General Dynamics stock is a "buy," you need to look beyond any one arms sale, no matter how profitable, and examine the valuation of the stock as a whole. So let's do that:

DATA SOURCES: YAHOO! FINANCE, S&P GLOBAL MARKET INTELLIGENCE.

What can we tell from this chart? Well, right off the bat, General Dynamics' price-to-earnings (P/E) ratio looks pretty expensive relative to its slow projected growth rate. The 18.8 P/E, divided by 7% growth, works out to a PEG ratio of nearly 2.7. (Value investors generally prefer to invest in stocks selling for a PEG ratio of 1.0 or below.) Even factoring in the 1.8% dividend yield brings the stock's total return ratio down to only 2.1.

Both those valuations seem expensive (an impression reinforced by the 1.7 P/S ratio, which is about 70% above my rule-of-thumb valuation for defense stocks). Meanwhile, General Dynamics' free cash flow has been lagging reported net income of late, with the result that the company's price-to-free cash flow ratio (48.9) looks expensive in the extreme.

So what's the upshot of all this? General Dynamics is a terrific company, big, profitable, and winning business around the globe. General Dynamics is not, however, a cheap stock. If you're looking for bargains in the defense industry, you're best advised to look elsewhere.