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This Just In: General Dynamics Stock Upgraded After Earnings

By Rich Smith – Apr 25, 2019 at 3:09PM

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JPMorgan removes its underweight rating on the defense contractor.

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

It's been a tough 12 months for General Dynamics (GD -0.26%) investors, who've watched the company steadily outperform analyst earnings estimates in each of the last four quarters -- and watched General Dynamics stock sink 16% regardless.

General Dynamics did it again yesterday, beating estimates for both earnings and revenue, reports, yet its stock fell on the news -- and is down again today. Despite these disappointing reactions, however, this morning analysts at JPMorgan announced they are removing their underweight rating and upgrading General Dynamics stock to neutral.

Here's what you need to know.

Tumbling dice read buy and sell

Image source: Getty Images.

General Dynamics reports

General Dynamics reported its fiscal Q1 2019 earnings Wednesday morning. Revenue grew 23% to $9.3 billion, easily beating analysts' consensus expectation for $8.8 billion. Profits on those sales, however, were down 3% to $2.56 per share, but still ahead of Wall Street's expected $2.42 per share.

General Dynamics enjoyed sales growth in all five of its key divisions. Revenue growth was strongest in IT (where last year's acquisition of CSRA boosted results) -- up 91% year over year. Combat systems (tanks and other armored vehicles) saw sales increase 14%, and aerospace revenue -- primarily Gulfstream jets -- jumped 23%.

Profits-wise, however, earnings on these growing revenues declined in three of the five divisions, with earnings rising only at missile systems (up a bare 1%) and IT -- where earnings grew 54.5%, a far slower rate than you might expect given the 91% increase in sales. IT also remains General Dynamics' weakest division in terms of profit margin, with the business earning only about an 8.9% operating profit margin versus 13.4% for the company as a whole.

General Dynamics predicts

As for what comes next, General Dynamics noted that its book-to-bill ratio in the quarter was a very strong 1.2, helping to push total backlog up 11% to $69.2 billion. Combined with estimated potential work, management said its "total potential contract value" is up 18% year over year at well over $103 billion -- close to three years' worth of revenue for the company, and indicative of further strong sales growth.

Nevertheless, in its earnings conference call with analysts, General Dynamics' management undermined any optimism investors might have gleaned from this news by warning that Q2 2019 earnings will probably be "very similar" to what the company earned in Q1. Assuming this is how things play out, and General Dynamics earns only $2.56 per share again in Q2, that will fall short of Wall Street's consensus prediction for earnings of $2.74 per share.

I suspect it's this prospect of Q2 turning into an earnings miss that sent General Dynamics stock down yesterday, and is continuing to pressure it today.

JPMorgan's ratings: Then and now

And let's give credit where credit is due. JPMorgan seems to have foreseen General Dynamics' problems when it assigned the stock an underweight rating more than a year ago. In particular, JPMorgan warned back then that profits would soon come under pressure in the company's all-important Gulfstream division, where a year ago it was earning an operating profit margin of 19% -- but today it's earning just 14.6%.

So what are we to make of JPMorgan saying today that it thinks the worst may be over for General Dynamics, that there are now "fewer obstacles ahead" for the company, and that the stock's valuation -- about 15.8 times earnings -- looks "reasonable?"

Well, on the one hand, this seems to tally with management's own comments that "issues" with its Gulfstream division will soon "be behind us." Sales are going great guns, even if profit margins are sagging, but an improvement in aerospace results could in theory fix that. It's at least possible that, in upgrading General Dynamics stock to neutral, JPMorgan is right about it being appropriately priced today.

That being said -- I do not believe that now's the time to buy.

Sure, 15.8 times earnings doesn't look particularly expensive in a market where the average S&P 500 stock costs more than 22 times earnings. I can't help but notice, though, that General Dynamics' price-to-sales ratio today is about 1.4, and the average long-term P/S ratio for the stock has historically been more like 1. Sure, rising sales could be one way that the company shrinks that gap between current and former P/S ratios. But I think it's just as likely that profit margin will continue to decline, eliminating the logic for investors assigning higher-than-average value to General Dynamics' sales, and keeping pressure on the stock price.

From that perspective, I have to wonder if JPMorgan is pulling its underweight rating too soon. As for me, I think General Dynamics stock is still going down.

Rich Smith 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.

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