Yann Coquoz is a Portfolio Manager at Foyil Asset Management, a value-oriented private investment firm. The below investment thesis was originally posted on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors.
Thesis Quick Pitch
At a current price of $67 per share, "Mr. Market" is offering investors an amazing business at a fraction of its intrinsic value. General Dynamics (NYSE: GD) is the perfect business to own: It has a predictable, consistent recurring revenue stream derived from multiple sources, a very significant market share (current market cap of about $24.6 billion), a solid balance sheet to help it withstand severe market fluctuations/conditions, and it is run by a very capable management team that has been able to consistently expand the business at a strong pace and at a cost that is less than its return on investment.
So why is it trading at such a low price? A recent announcement by the Obama administration of planned cuts in military spending has sent the entire defense/aerospace industry on a downward spiral. General Dynamic's stock has fallen more than 18% from its yearly high following this announcement, and is trading at a price level that offers very high downside protection, and at such a discount to intrinsic value that it provides a strong enough margin of safety. GD offers such a broad platform of products and services, and has such a diverse customer base and revenue stream that the true impact of this "spending cut" will not even be felt by the company.
In summary, we have been presented with a fantastic company that is trading at a huge discount to its intrinsic value because of a short-term market panic, caused by investors acting irrationally. It is your classic value investing opportunity.
Brief Business Overview
General Dynamics operates in two primary markets: defense and national security, and business aviation. The corporation offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; shipbuilding design, construction and repair; and information systems, products and services. It operates primarily through four business groups -- Aerospace, Combat Systems, Marine Systems, and Information Systems and Technology. Primary customers are the U.S. military, other U.S. government organizations, the armed forces and governments of other nations, and a very diverse base of corporate, government, and individual owners of business aircraft.
Financial Analysis: Growth, Efficiency and Profitability, Capital Structure
Growth: Since 2000, the company has seen consistent annualized revenue growth of 11.9%. Earnings per share (EPS) have grown at a 14.5% annual rate over the past 10 years, and at 16.5% over the past five years. Book value per share has grown 13.5% annually over the past 10 years, and 14% annually over the past five years. Free cash flow has grown annually at a rate of 15.2% during both the past five-year and 10-year periods. Dividends per share have grown 11.5% a year over the past 10 years, and 15% annually over the previous five years.
These numbers show that the company is growing at a consistently strong rate, but more importantly, this growth is coming from the correct sources (revenue/sales growth), not from management's "creative" use of accounting standards. Furthermore, this growth is parallel across all aspects of the company: free cash flow (FCF), revenue, EPS, BV/S, dividends, and retained earnings are all growing at about the same rate.
Moving on, the one growth figure we like to see decreasing year over year is capital expenditures. As a percentage of net earnings, capex has decreased from 21.7% in 2004 to 16.1% in 2009. So the growth in revenue and earnings has not been accompanied by an equal growth in capital expenditures; in fact, capex has actually decreased as revenue has increased.
It doesn't matter how quickly or large the growth in revenue or earnings is if the cost of this growth is greater than the returns. This is one of the most amazingly significant but simple rules of business. GD has shown that it can consistently grow at a rate greater than the cost of growth, and that large capital expenditures are not consistently needed. This is a very strong point.
Efficiency and Profitability: Return on equity (ROE) has averaged 19.4% over the past 10 years, and return on assets (ROA) has averaged 8.1% during this same time period. Gross margin has averaged 17.4% over the past 10 years, operating margin has averaged 11.2%, and net profit margin has averaged 7.4%. These numbers are OK, but nothing to write home about. However, an important observation to be noted from these ROE and ROA figures is that they are consistent year over year, just like the growth figures.
A favorite figure of mine to look at is FCF/Sales. This shows the amount of each dollar of revenue that is converted to excess profits. GD has averaged 7.4% a year since 2000. Once again, General Dynamics continues to show extremely low volatility in its business, as these figures show very low year-over-year variation.
CROIC -- cash return on invested capital (i.e., FCF/invested capital) -- is a very significant metric when it comes to analyzing a business, because it simply shows how much free cash flow per dollar the business generates from invested capital (including debt-financed capital). General Dynamics has been able to increase this figure from 26.5% in 2004 to 40.6% in 2009. These numbers are very high and trending upwards, showing clearly how effective management is as well as the strength of the business.
Capital Structure
General Dynamics is sitting on a very solid balance sheet. Total long-term debt of $2.4 billion can easily be covered with current trailing-12-month (TTM) net earnings. FCF as a percentage of short-term debt is about 350%, and as a percentage of long-term debt is about 112%. Interest as a percentage of operating income has fallen from 7.6% in 2004 to 4.4% in 2009. Depreciation expense (as a percentage of gross profit) has remained steady at about 10% over the past five years.
The CR is at about 1.3x, and the debt/equity ratio is nothing to be worried about, currently at a manageable 133%. General Dynamics has one of the strongest balance sheets among its peers with a low long-term debt-to-capitalization of 19.1% at the end of the third quarter 2010. This compares very favorably to industry averages around 95%.
One section of General Dynamic's balance sheet that needs to be accounted for is the company's underfunded pension liabilities, which is about $3 billion; this amount will be deducted from the company's target price in the valuation section.
Moving on, management has been consistently buying back shares and increasing dividends at a very solid pace, suggesting two things:
- Management thinks the stock is undervalued, which should provide current shareholders with long-term value.
- There is strong confidence from management about the recurring predictability and strength in the company's ability to generate internal FCFs.
The company has been buying back about 2.5% of its stock per year over the past three years, and aggressively bought back shares when the stock was at its low in 2008, which has provided great returns for its investors and shows a company that is run by a management that cares about its shareholders. Specific numbers: The company repurchased 3.6 million shares during fiscal 2009 and 11.2 million shares in the first nine months of 2010. Also in March 2010, the company raised its regular quarterly dividend by 10.5% to $0.42 per share.
GD has also effectively used its retained earnings to grow its earnings per share, earning a return on its retained earnings of 15.6% over the past five years and 14.2% over the past 10 years. Again, this shows that management is effectively using its earnings.
Summary and Valuation
The three sections we just went through show us that General Dynamics is a very strong company that has the ability to consistently generate free cash flows for its investors, and is able to grow this free cash flow year over year at a rate greater than the cost of its growth. In addition, the company is run by a very capable management team that constantly acts in the best interests of shareholders. Now to the intrinsic value calculations.
Before I start any DCF calculation, I like to see what the current price of the stock factors in relating to growth and discount rates. At a price of $65.17 per share, and using the FY 2009 FCF figure of $2.43 billion (which is lower than the current TTM FCF figure of $2.7 billion), the current share price assumes growth of 4.25% annually for the next 10 years ending with a terminal growth rate of 5%, all discounted at 13.5%. (Please note that the 4.25% annual growth rate declines by 10% for years 4-7 and another 10% for years 8-10.)
The market is assuming that the company will only be able to grow at a rate of about 4.3% for the next 10 years. This is severely below General Dynamic's five- and 10-year historical averages.
Now these are the following assumptions for my own estimates:
- FY 2009 FCF of $2.43 billion
- Growth rate of 10% for the next 3 years, declining to 9% for years 4-7, further declining to 8.1% for years 8-10, and then 5% for years 11-20
- Discount rate of 10%
This leads to a DCF valuation of $102.45 (which includes pension liabilities of $7.80/share).
If we were to use GD's average growth rate of 14% and a discount rate of 10% (and the same decaying growth rate assumptions as above), the target price would be $128.90.
If we were to use the same growth rate of 14% and a higher discount rate of 12%, the target price would be $108.97 per share. I've used rather low discount rates due to the past predictability and consistency of GD's recurring revenue streams.
Target price range: $105-$129. Margin of safety: 60%-100%.
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