General Dynamics (GD 0.54%) had a mixed year in 2017, posting a full-year 17.83% stock gain and hitting multiyear highs in terms of price-to-earnings ratio and other metrics, yet still trailing most of its defense peers. Will the story of 2018 be one of further gains, or regression toward historical averages?
Growth ahead
Shares of GD, a maker of Abrams tanks, nuclear submarines, and a range of other armaments, along with shares of other defense contractors have been trending higher since the 2016 U.S. election on investor anticipation that Republican control of the White House and Congress would lead to higher Pentagon spending. The company's latest results showed that those expectations have not yet become reality, with GD reporting fourth-quarter 2017 revenue of $7.28 billion that was up from last year but below estimates.
A Gulfstream G650 business jet in flight. Image source: General Dynamics.
CEO Phebe Novakovic blamed the miss on General Dynamics' failure to convert its backlog into revenue as quickly as it had hoped, blaming slowness in the transition to a new administration and the use of continuing resolutions to fund the government. She said shorter sales-cycle businesses like government IT contracts had been stalled.
The good news going into 2018 is that General Dynamics believes the revenue is only delayed, and will not be lost altogether, meaning the company is set up well going into the new year. General Dynamics expects to generate between $32.35 billion and $32.45 billion in sales this year, a 4.4% to 4.8% improvement over 2017, with an operating margin of about 13.1%. GD's operating margin for 2017 came in at 13.5%, which was higher than it had forecast.
"We are quite bullish about the 2018 through 2021 period in all segments," Novakovic said during a Jan. 24 call with investors.
Specifically, President Trump's plan to refresh the Navy should provide significant opportunities for General Dynamics in the years to come. And while its ground systems offerings are not a current Pentagon priority, the company is enjoying success selling them globally.
Gulfstream stabilizes
It is General Dynamics' Gulfstream unit that has been holding the company back in recent years, as the business jet market has so far failed to rebound much off of 2009 lows. It now appears Gulfstream might have bottomed out. Net orders for the unit were up 20% year over year, with large cabin orders up almost 30%.
The company's mainstay G650 saw orders grow 78% year over year, making it the best order quarter for the jet since 2014, and the second best since its launch in 2008. Gulfstream now has more than 280 of the jets in service, meaning a significant customer list to service for years to come.
There is reason for optimism that tax reform could lead to further interest in business jets. Given the strength of General Dynamics' defense business, even a stabilized Gulfstream without growth would be a positive development and could be enough to move General Dynamics out of the penalty box.
So, is it a buy?
Given how far defense stocks have come since the 2016 election, it's hard to call any one of the primary defense contractors (primes) a strong buy at these levels. But General Dynamics appears the best of the bunch, largely thanks to Gulfstream. The commercial unit has been an albatross in recent years, keeping General Dynamics at a discount to other large contractors. But if the worst is now over for business jets, what once was a headwind could now be a catalyst.
Defense 10-year price and PE ratios data by YCharts.
Defense spending increases have taken longer than expected to materialize, but even if the growth comes slow, it seems the trajectory of the Pentagon budget is headed in the right direction. General Dynamics is not cheap, but it is the best defense stock to buy right now for a long-term portfolio seeking to take advantage of spending increases.
