General Dynamics (NYSE:GD) has been the laggard among large defense firms for the better part of the decade, and the explanation for the underperformance largely comes down to one business unit, Gulfstream, that has struggled to get airborne.

But it appears Gulfstream is finally on the upswing. On April 24, General Dynamics reported first-quarter revenue and earnings that came in ahead of expectations, in part due to signs of a resurgence in that once-struggling unit. GD earned $2.56 per share on revenue of $9.3 billion, easily topping analyst expectations for $2.42 per share in earnings on sales of $8.84 billion. The company's total backlog at the end of the quarter was $69.2 billion, up 11.4% year over year.

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Results from the company's defense units were choppy, meaning that investors still need to be on guard. But a recovery at Gulfstream, after several false starts in recent years, would be significant. If Gulfstream really is ready to take off, shares of General Dynamics can gain altitude as well.

Here's a breakdown of the quarter, and what to expect from General Dynamics in the quarters to come.

Gassing up the engines

Aerospace has been an albatross weighing on General Dynamics' results for the better part of a decade. Gulfstream, along with the broader business-jet market, has yet to fully recover from the 2008-2009 recession. But a range of factors, including fleet age and new depreciation rules included in last year's tax legislation, have investors hoping for a resurgence.

Gulfstream's G500 in front of a hangar

Gulfstream's new G500 business jet. Image source: General Dynamics.

Gulfstream has new products including the G500, which launched last year, and the G600, which it hopes to launch this summer, to sell into the expected growing demand. The recovery never materialized in 2018, in part because of a supplier bankruptcy, but it appears those issues are largely behind it.

Gulfstream reported 34 deliveries in the first quarter, up from 24 in the first quarter of 2018; it finished the quarter with a book-to-bill ratio of 1.42, 62 basis points ahead of a year prior, thanks in part to a $1 billion order from a single unnamed customer. The company said its backlog grew for both the G600 and G500 in the quarter, with demand particularly strong in the United States but also with early signs of growth in China.

General Dynamics has moved to take control of some of the issues that led to last year's delays. In mid-2018, the company bought a manufacturing line from bankrupt supplier NORDAM Group to ensure supply of the nacelles for the engines on the G500 and G600 and resolve manufacturing delays caused by a lack of supplies.

Gulfstream expects the G600 will be certified by the end of the current quarter, with deliveries beginning in the second half of the year. On a call with investors, company chairman and CEO Phebe N. Novakovic said she expects sales to trend higher in the quarters to come: "We're in a period of solid, but not overheated demand, and I see nothing in the data available to me at the moment that suggests a change in that picture."

Improvements at Gulfstream will take time to hit the bottom line; margins on airplane programs tend to increase over time, as volume grows and early development costs are paid for. Investors should expect Gulfstream margins to increase significantly in 2020, and again in 2021.

Revenue stronger than profits in defense

General Dynamics' defense businesses had more of a mixed quarter. Sales grew in all four defense units, but profit fell in the ground-vehicle and shipbuilding divisions, and underwhelmed elsewhere.

Overall profit margins at the four defense businesses declined to 9.8% from 11.5% last year, due in large part to the number of early-stage projects General Dynamics has on its books. Older contracts tend to be the most profitable; newer programs like the Navy's Columbia-class ballistic submarine, expected to be the most expensive new boat program on record, tend to compress margins because of the research and development and the tooling that go into new work.

"When you're growing and you've got new contracts coming in, and you've got older contracts closing, you're going to have the mix issues. And we, frankly, because all of our defense businesses are growing, we have some of that right now," Novakovic said on the call. "We are very good at improving what we control, and we control our own operations. So you can expect us to get better and better and better as time goes by."

A Virginia-class submarine sales in front of the sunset.

A GD-made Virginia-class submarine. Image source: General Dynamics.

General Dynamics' IT business, which expanded last year via the company's $9.6 billion acquisition of CSRA, was the worst performer in terms of operating margin, at 7.2%. Company officials attributed the profitability in part to its mix of business; hopefully, GD will use its newfound scale to compete for more lucrative business than either GDIT or CSRA won on their own.

GD officials also see IT as an area with more stable revenue, and with opportunities for long-term growth, as the government increasingly turns to outside contractors to manage computer systems and other technology. Admittedly that's not a universally held view, as many of GD's defense rivals have divested their IT units.

It's time to buy in

Every large defense contractor today, perhaps with the exception of Lockheed Martin, has its share of strongly performing and underperforming businesses, based on the relative age of contracts and the Pentagon's procurement priorities. What has made General Dynamics stand out in recent years is Gulfstream, but the company has not stood out in a positive way.

General Dynamics trades at a price-to-sales multiple 10% lower than its closest defense rival, and trails most of the defense patch in its enterprise value to EBITDA multiple. This is while it also pays a dividend yield that, at 2.14%, trails only Lockheed.

Gulfstream was the primary reason for General Dynamics' valuation gap; its recovery is an opportunity for the company's shares to outperform its peers as that gap closes. It's not going to happen overnight, but the case for owning General Dynamics is growing stronger by the quarter.