General Dynamics (NYSE:GD) has been the "wait 'til next year" story of the defense industry for several years now. The company's initial guidance for 2019 suggests that investors are going to need to be patient a while longer.
The company reported fourth-quarter earnings of $3.07 per share, surpassing the $2.99 per-share analyst consensus, thanks to the impact of a lower tax rate and decreased share count. But the operating results fell short of expectations due to weaker-than-expected margins in its Gulfstream business and delivery delays in its combat unit.
Overall operating margin for the quarter was 11.8%, down from 12.8% a year prior, despite revenue of $10.38 billion that was up 25% from the same period last year and came in slightly better than expectations.
Wall Street initially deemed the results good enough, sending General Dynamics shares up 4% on Jan. 30 after the release, but the shares went into the red as company execs discussed guidance during a conference call that followed. General Dynamics forecast 2019 earnings of between $11.60 and $11.70 per share, below analyst expectations for $12 per share, and sales growth of 6% compared to expectations for 8% gains.
Here's a look at what went wrong, and right, at General Dynamics in the quarter, and why despite the disappointing 2019 guidance the company could still be an attractive buy.
The good couldn't outweigh the bad
General Dynamics reported uneven results in the fourth quarter from its various operating units, with its marine and IT businesses exceeding expectations but unable to fully offset weakness elsewhere. Gulfstream's margins came in more than 1% below expectations, and the combat unit fell victim to ongoing tensions between the governments of Canada and Saudi Arabia.
In December, Canadian Prime Minister Justin Trudeau said he was looking into ways to back out of a $13 billion sale of General Dynamics' Canadian-made armored vehicles to the Saudis in response to the killing of journalist Jamal Khashoggi and Saudi Arabia's involvement in the Yemen war.
The controversy cost General Dynamics about $300 million in expected fourth-quarter revenue, enough to spoil the quarter.
Company chairman and CEO Phebe N. Novakovic, on the call with investors, expressed confidence that the deal will eventually go through, calling the miss "a timing issue" and saying "We're quite comfortable and quite confident that that will resolve, just at a slower rate than we had anticipated."
At Gulfstream, the company had forecast improvements thanks to its refreshed product lineup and as it clears up an issue with a supplier that had prevented it from being able to guarantee delivery slots. But the unit's margins came in more than 1% below expectations due to the costs of ramping up production, and its 0.82 times book-to-bill for the quarter was below the recent trend.
Novakovic said on the call that Gulfstream "had very nice order activity last year" and that the fourth quarter "was about what we anticipated," adding that Gulfstream's quarter would have looked much better had a pending $1 billion order that is awaiting approval of the unnamed customer's board gotten onto the books before year's end.
The year ahead
While the issues that dinged fourth-quarter earnings can be explained, the outlook for 2019 was underwhelming. The company is expecting little organic sales growth from its massive IT unit, which became one of the largest in the sector in 2018 thanks to General Dynamics' $9.6 billion purchase of CSRA. The company is also forecasting an operating margin in its marine group of 8.5% compared to 9% for 2018, due to a younger product mix, though Novakovic did say on the call that GD had the potential to outperform that number.
The combat unit similarly is forecast to see a slight margin decrease, likely due in part to the drag caused by the issues with Canada, though Novakovic does expect "revenue, earnings, and margin rate to grow quarter-over-quarter" with a "particularly strong" fourth quarter.
But it's Gulfstream, which in good times should easily be General Dynamics' most profitable sector, that continues to weigh most heavily. General Dynamics expects Gulfstream to generate a margin of 15.5% for the year, compared to 17.6% in 2018, due to start-up costs associated with new designs, the impact of pre-owned sales that generally carry little margin, and the lingering effects of supply chain woes.
As with the combat unit, Novakovic expects Gulfstream to improve as the year goes on, growing from $2.2 billion in expected revenue in the first quarter to $2.8 billion in the last three months on the year, and margins moving from the mid-14% range to "well over 17%" by the fourth quarter.
"We believe that last year will be the low point in operating earnings during this transition to our new models with modest earnings increases in 2019 and 2020, and significant earnings traction thereafter," Novakovic said.
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All eyes on 2020
General Dynamics, in short, is forecasting a rough start to the current year but hopes to see momentum build in key areas as 2019 progresses. In theory, the company should be set up nicely for 2020, as Gulfstream's new models hit their stride, the amount of new-business engineering work decreases at the company's marine unit, and some of the short-term issues that have plagued other units are resolved.
There is even hope for an influx of new business, as GD is among the favorites to land a contract as the U.S. Army campaigns to modernize its 40-year-old Bradley Fighting Vehicle and other land systems.
Shares of General Dynamics are up 67% over the past five years, besting the S&P 500 by more than 14%, but the company has been the laggard among defense firms due largely to Gulfstream and the business jet market in general not yet recovering from the 2008-2009 recession. General Dynamics still trades at a discount to the other defense titans, with its current multiple to earnings between 8% and 23% lower than its peers.
As Gulfstream ramps up production that discount is likely to shrink, a belief that has led me to declare General Dynamics the best buy among defense giants. The timing of that pick is questionable following the company's initial guidance for the year, but I stand by the rationale and continue to believe in the stock. I also suspect that the guidance is conservative, and the hoped-for improvements will materialize in time to hit quarterly statements in the second half of the year.
It's not going to come as quickly as I had hoped, but I do believe General Dynamics will reward investor patience in the quarters to come.