With all the recent talk of spending cuts, I have a hard time getting excited about defense stocks. Nearly every major contractor reported lackluster results for the first quarter, and unless the country finds itself in yet another war, I believe the industry's earning reports will continue to underwhelm.
But I'm not totally down on defense stocks. The near future will be a bit rough, but in the long term, companies such as General Dynamics
Shrunken backlogs
A defense company's backlog is the total value of sales orders waiting to be filled. If all goes well, the company will deliver on the contract and get paid. Ideally, I'd like to see backlogs grow, but between the continuing budget negotiations and Defense Secretary Robert Gates' cuts, first-quarter backlogs took a hit.
|
Company |
March 2011 Backlog |
March 2010 Backlog |
|---|---|---|
| General Dynamics |
$57.6 billion |
$63.9 billion |
|
Northrop Grumman |
$43.7 billion |
$67.5 billion |
|
Raytheon |
$55.4 billion |
$57.2 billion |
Gates' decision to cancel the Marines' $15 billion program to develop the Expeditionary Fighting Vehicle no doubt contributed to the decrease in General Dynamics' backlog. It's also very likely that the Defense department will have to cancel more programs as it seeks to cut spending. As a result, I don't see much growth for General Dynamics and the rest of the defense industry for a while.
Why the optimism?
Even though the next few years might be rough, General Dynamics is a strong company, and its backlog has a couple of bright spots. The U.S. Navy has increased its order for Virginia class subs to two a year, while growing demand for swank Gulfstream jets increased the company's aerospace backlog for the second consecutive quarter, to $17.9 billion. The company believes that the business aviation market is improving, and an improvement here should help offset decreases in the company's defense-related businesses.
What gives me the most hope for the company is that even though Raytheon and Northrop Grumman both generated negative free cash flow for the first quarter, General Dynamics' FCF increased year over year, from $147 million to $266 million. Since FCF measures how well a company manages its cash, it can give you a better picture of a company's profitability than looking at earnings alone. A company can report positive earnings while also having a negative FCF, but over the long term such a situation is unsustainable. Because General Dynamics' FCF is both positive and growing, the company appears to be quite healthy. Even if it's unlikely to grow explosively -- or much at all, really -- in the short term, General Dynamics should have no trouble riding out any deep cuts in defense spending.
Interested in keeping an eye on General Dynamics? Add it to your Watchlist.
