It's been a pretty good season for earnings for America's biggest defense contractors so far, with Lockheed Martin, Northrop Grumman, Raytheon, and General Electric all queuing up to report "earnings beats" in quick succession -- and only Boeing, so far, sounding a sour note. On Wednesday, General Dynamics (GD +0.41%) was the latest defense heavyweight to wow Wall Street with better-than-expected profits.
And yet, there's one thing about General Dynamics' earnings that should perhaps give investors pause.
NYSE: GD
Key Data Points
General Dynamics by the numbers
Reporting for its first fiscal quarter 2023, General Dynamics waltzed right past Wall Street's predicted $9.3 billion in sales to report a $9.9 billion quarter -- up 5% from last year's Q1. Per share profits beat expectations by a nickel, coming in at $2.64 per share. Free cash flow for the quarter was $1.3 billion -- nearly twice the company's $730 million net profit.
Sound good so far? Well, buckle up because this story's about to take a turn.
Start with that free-cash-flow (FCF) number -- contrasted with accounting profits, the measure of how much actual cash General takes in after deducting for capital spending. General Dynamics' FCF was much better than the headline net income number. Still, it was down precipitously from the $1.8 billion in FCF the company generated in last year's Q1.
Next, take a look at General Dynamics' revenue. While beating expectations by a cool $600 million sounds good, most of General Dynamics' revenue growth arrived by way of its second-biggest revenue segment, Marine Systems, which expanded sales by 13% in the quarter.
The problem is that Marine Systems also generates General Dynamics' worst profit margins, just 7.1%, or barely half the profit margin of General Dynamics' most profitable Combat Systems division (which builds Abrams Main Battle Tanks) -- and it's where sales grew less than 5%, and profit margins shrank by 90 basis points.
Result: Despite growing sales by 13%, Marine Systems' profits showed absolutely no improvement -- flat against last year's number.
General Dynamics' most important number
All of that might be fine. After all, one of the benefits of being a diversified business that makes money selling everything from tanks (Combat Systems) to submarines (Marine Systems) to IT services (Technologies) to Gulfstream jets (Aerospace) is that when one division slacks off a bit, another can pick up the slack. What worries me more about General Dynamics today is a different number entirely:
Its book-to-bill ratio.
An important metric for defense contractors that maintain years-long backlogs of orders to be filled over time, a company's book-to-bill ratio compares the value of new contracts won in a quarter (contracts "booked") to the value of older contracts fulfilled (contracts "billed"). As such, it gauges the health of all of a company's several businesses at one time. Over time, contracts won turn into new revenue collected, such that one way to look at book-to-bill is as a predictor of future revenue growth.
Or the converse: Revenue decline.
At General Dynamics, the book-to-bill ratio that had been climbing steadily over the past year -- 1.0 in April 2022, 1.1 in July and October, and 1.2 in January -- took a turn for the worse in Q1 2023, falling to 0.9. While I'd call one quarter's snapshot number, at worst, a yellow flag for the stock -- not yet a red flag -- it is a bit worrying to see new orders slowing down. It signals a company's potential -- one that grew sales only 5% in Q1, remember, and grew earnings just 1% -- to see its growth slow further in future quarters or even decline.
Considering General Dynamics was not a particularly cheap stock, to begin with (its 17x price-to-earnings (P/E) ratio masks rather weak free cash flow over the past year, pushing its price-to-FCF ratio closer to 20), the prospect of growth slowing even further from its current low-single-digits rate is probably a better argument in favor of selling General Dynamics stock rather than buying it.
