In a vacuum, a 15.63% year-to-date gain would be something to celebrate. But in the case of General Dynamics (NYSE:GD), whose top rivals are up between 26.5% and 30.95%, as the S&P 500 is up 18% for the year, that 15% move is tough to get too excited about.

It would be wrong to say things are not going well for General Dynamics. But at least from the market's perspective, things seem to be going less right for it than they are for other defense contractors. Even on a three-year or five-year horizon, General Dynamics' shares -- though up 41% and 192%, respectively -- have underperformed those of Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), Raytheon (NYSE:RTN), and Huntington Ingalls (NYSE:HII).

Gulfstream G500

The Gulfstream G500, set for introduction in early 2018. General Dynamics could use a strong showing from its new business jet. Image source: General Dynamics.

Here is what's going on at General Dynamics, and what the future might hold.

Diversified in all the wrong ways

Defense stocks including General Dynamics have been up on anticipation that, after years of budget battles, single-party control in Washington would lead to higher levels of Pentagon spending. Some level of increase seems likely, but it will not be spread evenly to all contractors.

A refresh of the U.S. Navy fleet would benefit General Dynamics, as the company is one of the two primary shipbuilders, but that refresh is expected to be spread out over a decade or more and will take time to flow to the bottom line. The other important Navy shipbuilding company, Huntington Ingalls, also has more capacity at its shipyards to pick up any immediate additional work.

GD Chart

Defense stocks year-to-date. data by YCharts.

One area of particular General Dynamics strength, its land systems unit, which manufactures tanks and other armored vehicles, is not high up on the Pentagon priority list.

General Dynamics has also been weighed down by its Gulfstream business jet unit, which has underperformed since the 2009 recession. Aerospace accounts for about one-quarter of General Dynamics' total revenue, and while the business has seen a slow uptick in sales (3.6% higher in the third quarter compared to the same three months of 2016), there isn't yet a clear sign that new biz jet sales are about to take off.

The gap could close in 2018

Despite trailing the performance of other contractors, General Dynamics is hardly a value stock. Shares of the company trade at 18.91 times trailing-12-month earnings and 1.91 times trailing-12-month sales, both at or near 10-year highs. But that's true of the entire sector, and if investors are insistent on buying into defense even after years of price gains General Dynamics is one option to consider.

The General Aviation Manufacturers Association in November said that the business jet market seemingly has stabilized, with third-quarter sales up 1.4% year over year. If Gulfstream, which is historically among GD's most profitable businesses, can begin to show growth, investors might move GD out of the penalty box and give the company a multiple more in line with its rivals.


TTM P/E ratio

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Data source: Yahoo! Finance

Even without Gulfstream, General Dynamics has some levers it can pull. The company wins the battle of the balance sheet, with a sector-best debt-to-equity ratio. That gives it tremendous flexibility to make an acquisition to expand its presence in areas ripe for Pentagon growth. Aerojet Rocketdyne, maker of propulsion systems used in missiles and missile defense, is often mentioned as a potential GD target.

If the money doesn't go toward a deal, General Dynamics should continue to distribute cash to investors. GD has raised its dividend for 26 consecutive years and through the first nine months of 2017 has spent $1.9 billion on buybacks and dividends. The company has pledged to return whatever free cash flow that does not go toward M&A to shareholders.

That a stock up 15% on the year can be discussed as a disappointment says a lot about what a tremendous year it has been for defense shares. It's hard to predict how long the momentum will last, particularly as it seems the rally has gotten ahead of actual growth prospects. That said, it wouldn't be a surprise if General Dynamics is able to make up some of the gap in the next 12 months.


Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.