Investors Swoon Over General Dynamics' Earnings

Sales down? Weak guidance? What's all the fuss about?

Rich Smith
Rich Smith
Jan 30, 2017 at 3:57PM

I unabashedly admit: I'm a fan of General Dynamics (NYSE:GD) stock.

Look all around Wall Street any quarter, and you're unlikely to find another company -- certainly no other company in the defense industry -- that does a better job of laying out its financial results in a clear, concise form than does General D. When earnings day rolls around, General Dynamics gives you all the important numbers you need to know, right up front.

Earnings? Check. Revenue? Check. Profit margins, broken down easily by segment? Check. Free cash flow? Backlog? Guidance for the year ahead? Check, check, and check.

Human hands typing on a calculator.

A basic command of the English language and a small calculator are all the tools you need to understand General Dynamics' quarterly earnings reports. Image source: Getty Images.

I'd even go so far as to say that for a beginning investor, looking to dip a toe into the stock market by buying an easy-to-understand, forthright-in-its-reporting company, buying General Dynamics stock would be a great start -- if the price is right.

As for whether that price is right, though, well, let's take a look at Friday's earnings and find out.

The news

Announcing fiscal 2016 earnings on Friday, General Dynamics reported:

  • Sales declining by less than 1% for the year, to $31.4 billion.
  • But operating profit margins rising 40 basis points to 13.7%.
  • Net income per diluted share rose 5% to $9.52, but if you back out a $0.35-per-share charge for discontinued operations, General Dynamics beat (by $0.10) expectations of $9.77 per share.
  • On the other hand, free cash flow of $1.8 billion shrank 11% in comparison to last year's $2 billion haul -- and came in fully 40% below reported net income.

That last point aside, the year appears to have gone modestly well for General Dynamics, with the company parlaying share buybacks and a respectable improvement in profit margins into higher profits despite stagnant revenue. Investors' reaction to the news, however, was out of all proportion to General Dynamics' performance.

How investors reacted

General Dynamics stock soared 4.4% in response to Friday's news, hitting an all-time high of $185.14, and capping a 32.5% run the stock has enjoyed over the past 52 weeks. This was despite guidance that suggested General Dynamics' modest improvement in profits in 2016 will flatline in 2017.

According to management, this year will see a return to sales growth at the company, with revenue rising perhaps 2.5% to $31.4 billion. Profits, however, are projected to range between $9.50 and $9.55 -- roughly equal to the company's 2016 net.

So why are investors so eager to applaud modest growth in one year, coupled with promises of essentially zero growth in the next? The Wall Street Journal notes that, in its post-earnings conference call, General Dynamics promised bigger things in years to come, predicting that after 2017 is over, its sales will grow at an average rate of 5.6% annually through 2020. Assuming profit margins also hold up, profits growth could be even stronger -- but that's far from certain given President Trump's recent statements on the cost of General Dynamics' submarines. At the same time, General Dynamics' recent inability to translate reported earnings into real free cash flow anywhere near as robust is a matter of some concern.

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Valuing General Dynamics

How concerned should you be? Well, at $3 billion in reported income, General Dynamics' current $56.4 billion market capitalization values the company at 18.8 times earnings -- a steep price to pay for a stock that, according to estimates posted on S&P Global Market Intelligence, will only grow its profits at less than 9% annually over the next five years. When you consider further that, valued on free cash flow, General Dynamics stock is selling for a 31.1-times multiple, the overvaluation of the stock only becomes more obvious.

Long story short: General Dynamics is a fine company and turned in pretty decent results last week. It's got a bright future ahead of it, in which it will probably continue to post modest growth -- and yes, it has very shareholder-friendly management that does a great job of laying out its numbers so that anyone can understand them. General Dynamics' only problem, as I see it, is this:

Those numbers clearly show that the stock is overvalued.