General Dynamics Corporation (NYSE:GD) is quite possibly my all-time favorite defense contractor, and for a number of reasons. To name two, General Dynamics builds super-cool military hardware like the Virginia-class nuclear attack submarine and the Abrams main battle tank.
To name a third, it's quite possibly the easiest company to report earnings on, inasmuch as the company's earnings press releases generally confine themselves to a Spartan few paragraphs of "just the facts" that investors need to know. And today, investors got a fourth reason to love General Dynamics -- and it came in the form of one of these same earnings press releases.
Reporting its Q1 2014 earnings numbers, General Dynamics informed that:
- Revenues for the quarter were $7.3 billion. This was ahead of analyst estimates and, at just 1% less than the company collected in Q1 2013, the smallest revenue shrinkage we've seen at a defense contractor so far this earnings season.
- Operating profit margin expanded by 50 basis points, to 11.9%.
- In consequence, the company's net profit per diluted share increased 6% year over year, to $1.71.
So far, so good. And yet, I cannot quite bring myself to recommend buying the stock. Why not?
Valuation always matters
The answer basically comes down to valuation. In Q1 2014, the only real black mark I see against General Dynamics stock is the fact that its free cash flow -- the actual cash profits the company generates and gets to put to work immediately, as opposed to the GAAP accounting calculation of its long-term profitability -- declined year over year. Falling from $429 million in Q1 2013, to $341 million in Q1 2014, General Dynamics experienced a 21% plunge in cash profits.
In and of itself, this doesn't worry me too much. General Dynamics' trailing-12-month free cash flow tally is still a robust $2.6 billion, and 8% ahead of reported GAAP profits. But weighed against the company's market capitalization, the stock still costs 15 times trailing free cash flow. And if Wall Street analyst estimates are to be relied upon, this seems too much to pay for the 8% annual earnings growth that analysts are projecting for General Dynamics over the next five years.
A final thought, and a huge caveat
Note: That's if analyst estimates can be relied upon. The wild card in valuing General Dynamics stock, and in deciding whether it's a buy, is the fact that to date, General Dynamics is the only big, pure-play defense contractor this season to report that its backlog of work to be done is actually growing. According to management, the win of a big Canadian defense contract to sell light armored vehicles to Saudi Arabia could be a real game changer for this defense contractor.
Management is still keeping mum on most of the details of this contract in its public statements (although we gave you the lowdown on it in a column back in February). What management does confirm, though, is that the deal could be worth as much as $13 billion to General Dynamics over 14 years. Combined with other big contract wins in the quarter, management further confirms that this contract win helped boost General Dynamics' backlog of work to be done by an incredible 20% from where it stood just four months ago.
That means that not only is General Dynamics the defense contractor showing the least revenue slowdown of its peers today. It could also be the first defense contractor to show actual revenue growth in the future -- and potentially, leave all those downbeat analyst estimates for its profits growth in the dust. This is the kind of transformative development that can turn a seemingly expensive stock into a cheap stock in a hurry.