Army-tank maker General Dynamics (NYSE:GD) reported a big earnings beat Wednesday morning. (Hooray!) But its sales for the quarter were down year over year, and missed Wall Street estimates. (Boo!)

Profit margins for the quarter were up pretty significantly. (Hooray again!) But free cash flow, although up sequentially, still fell far short of reported net income. (Boo again!) And so, when all was said and done, and investors had had time to digest the news, they decided to sell the shares, sending General Dynamics stock down 2.2% on Wednesday, and another 1.6% on Thursday.

Was that the right call?

Abrams main battle tank in motion across sand

General Dynamics "beat" on earnings Wednesday, but investors said "tanks" for nothing. Image source: Getty Images.

General Dynamics by the numbers

Here's a quick blow-by-blow of how Q3 went for General D:

  • Sales declined 1% compared to last quarter, falling to $7.6 billion.
  • The operating profit margin earned on that revenue, though, expanded by 60 basis points to 13.9%.
  • As a result, operating profits grew despite revenue falling -- up 4%.
  • And on the bottom line, earnings per diluted share grew 20% to $2.52 (thanks largely to the lack of unprofitable, discontinued operations no longer dragging GD down).

In the end, CEO Phebe Novakovic described the quarter's performance as "strong," emphasizing General Dynamics' 13.9% operating margin and pointing out how the company grew its backlog by 9.2% over the past three months. But if you ask me, these two points could become double-edged swords threatening to cut off General Dynamics investors at the knees.

Here's how.

Profit margins -- or, "what goes up must come down"

Let's start with the margins, since that's what General Dynamics management chose to emphasize first. As I pointed out last quarter, General Dynamics' trailing-12-month operating profit margin hit an all-time high of 14.3% in Q2 -- the highest level of profit earned on revenue in the nearly 30 years over which S&P Global Market Intelligence has been gathering data on the company.

Now, Q3's "strong" performance has pushed that rolling average profit margin up once again, to a new all-time high of 14.4% earned over the past 12 months. On one hand, this sure sounds like good news. (More profits are good, right?) On the other hand, though, it's hard to imagine General Dynamics' profits rising to an all-time high and then just remaining there in perpetuity. Eventually, one imagines that profit margins must revert to the mean. And when that happens, General Dynamics won't be able to depend on expanding margins to deliver earnings growth -- not even single-digit growth.

Unless revenue starts rising strongly enough to offset falling margins, profits must go back down.

Backlog growth is in the eye of the beholder

Which brings us to revenue. Instead of rising, revenue declined by 1% last quarter. By highlighting rising backlogs, General Dynamics sought to allay concerns over falling revenue. (Backlogs are, after all, just future revenue waiting to be earned.) But here's the thing: Although General Dynamics' backlog grew 9.2% compared to Q2, it grew just 1.7% year over year. Moreover, the portion of General Dynamics' backlog that has been "funded" by Congressional appropriations declined by 1% -- right in line with the overall sales decline seen in Q3.

The upshot for investors

What does all this mean to investors? I wouldn't call it a "red flag" exactly, but I do think that a few yellow flags of caution are starting to unfurl at General Dynamics. Historically high profit margins combined with tenuous revenue growth is not a formula for strong profits growth, and with General Dynamics stock trading at or near a five-year high, I see the stock as especially vulnerable to any stumble in earnings.

When -- not if -- the defense cycle turns and General Dynamics begins reporting its inevitable declines in earnings, I expect the first step down is going to be a doozy for its stock.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.