5 Generals for Your Portfolio?

This is the second in a series of commentaries that will take a look at five companies whose names begin with the word "General." We recognize some of them as household names and as global conglomerates with operations (just like our military) throughout the world. The first company I recently reviewed was General Electric. This commentary is about General Dynamics (NYSE: GD). The three other companies I'll review later are: General Motors, General Mills, and General Communication.

As you might surmise, these corporate leaders have few similarities other than company names that all start with "General." The name is synonymous with leadership, and historically we have had both great and mediocre generals leading the fight. And so it is with these five companies.

Earnings quality is reflected in the financial statements
The Motley Fool offers two databases -- EQ Scan and EQ Score -- that are used to uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. To be fair, the GAAP rules are complex and open to interpretation that requires the employ of experts (i.e., CPAs). But, a critical eye on these statements can often uncover mistakes or trends that could be important for investors to understand before the battle has been lost.

When I review a company for earnings quality, I assign an index rank to the company from one (the lowest quality ranking) to five (the highest quality) and an associated numerical score -- similar to the "five-star" or "one-star" rank in the military. Different companies with the same index rank can have different numerical scores. As the company's financial status changes over time, we can adjust its rank and score. I look for trends that affect earning quality.

General Dynamics gets three stars

Among our "Generals," General Dynamicsperhaps best deserves to be called a general, as GD is one of four large defense contractors that supply hardware, software, and services to the U.S. and foreign governments. The others include Lockheed Martin, Northrop Grumman, and Raytheon. Like GE, GD was founded more than 100 years ago, and the modern corporate structure is organized in four groups -- aerospace, combat systems, marine, and information systems and technology.

It's safe to say that GD is heavily involved in all aspects of military and defense systems development and production -- land, sea, and air -- for use by both U.S. and foreign governments and commercial customers. It should be obvious that GD benefits from the wars that the U.S. and its allies are fighting in Iraq and Afghanistan -- as well as countless military actions that we rarely hear about -- wars that have been fought over the past decades.

What goes around comes around?
During times of war, defense contractors usually do well financially. Let's face it: War is big business. But when the enemies have been conquered (or not) and our citizenry has become weary of acting as the world's protector, then defense budgets are pared and programs canceled. This begs the question, "What can we expect for GD earnings going forward?"

Data from GD's financial statements:

Source: S&P Capital IQ, company presentations.

Anyone want to fight?
The negatives outweigh the positives for GD. Unless the U.S. enters yet another major conflict (Iran, maybe?), it may be hard going for defense firms, including GD. GD's revenue and earnings have been relatively flat YOY. But backlogs -- work waiting to be done -- have declined. Deferred revenue, or money collected before actual deliveries, has also declined. Accounts receivable shows steady growth, but days sales outstanding -- the time needed to collect revenue on a sale -- has grown from 97 DSO average in 2010 to 104 DSO in 2011. Clients, primarily the U.S. government, are slow to pay. In order to perform the work, the company added 5,100 workers during the last year and 11,100 workers since 2007. With backlogs and deferred revenue decreasing, this will surely cut into gross and operating margins going forward.

While GD's book value continues to grow, its tangible book value has been consistently negative due to the sizable goodwill carried on the balance sheet.

GD has used cash to reduce the number of common shares outstanding since 2007 by 47.6 million shares, which props up EPS. Also, GD has boosted its dividend during the same time frame to attract yield-hungry investors. If U.S. defense spending declines going forward, don't expect GD to continue to increase its dividend or buy back its shares. Anyone want to fight?

One thing General Dynamics certainly has going for it is a solid 2.6% dividend yield. If you'd like to check out some of our favorite dividend stocks, take a look at our special free report "Secure Your Future With 11 Rock-Solid Dividend Stocks." For free access to all 11 of these high yielders, simply click here.