On the face of it, General Dynamics (NYSE:GD) appears to be a highly appealing business in which to invest. It has four main divisions, with sales apportioned fairly equally among them. Its largest by sales is information systems and technology at 29%, while the smallest division is combat systems, which contributed 18% of sales in 2015. General Dynamics also supplies a range of products and services, from tanks to business jets. As such, many investors think that it's well diversified and, therefore, is a relatively safe investment. But is this really the case? Let's take a closer look.
High barrier to entry...
The idea that General Dynamics is a safe investment gains traction because of the space in which it operates. A number of companies would love to supply the same products and have the U.S. government as their main customer, as General Dynamics does. However, the barrier to entry in the industry is exceptionally high, and with the U.S. government's favored fixed-price deals transferring risk onto the supplier in case of project overruns or unexpected delays, many companies struggle to gain entry to the defense space. Therefore, General Dynamics, so the story goes, enjoys a lack of competition from new entrants and this should help it to deliver resilient and robust margins and profitability moving forward.
...But high risk
However, General Dynamics' reliance on the U.S. government for the majority of its business poses a major risk. Although it derives a lower proportion of its sales from the government than key defense competitor Lockheed Martin, with the figures standing at 57% and 78%, respectively, in 2015, getting the majority of its sales from one source can still be problematic. And with another of General Dynamics' large rivals, Boeing, relying on the government for just 27% of its revenue in 2015, it is clear that other companies in the defense space may offer greater diversity and lower risks, and still benefit from a high barrier to entry.
When one customer dominates a company's revenue, reduced orders from that one source can severely hurt overall revenue. In the case of the U.S. government, budget cuts are a huge threat to General Dynamics. Although the Bipartisan Budget Act of 2015 raised the defense spending cap for fiscal years 2016 and 2017 by $25 billion and $15 billion, respectively, General Dynamics still faces an uncertain future regarding budget fluctuations.
While such a risk would be a negative against any company that supplies the government with defense products and/or services, the effect on General Dynamics from budget cuts would be major simply because of its lack of customer diversity. And even though General Dynamics has its very profitable Gulfstream aerospace division, which reduces its dependence on the military space, as well as the aforementioned diversity of income streams among different product lines, its overreliance on one customer makes its risk profile relatively high -- especially when a key sector peer such as Boeing has far less reliance on the U.S. government.
An improving business
However, General Dynamics is making progress as a business, with 2015 being a record year in terms of earnings, margins, and return on sales. Furthermore, its strategy regarding reducing costs and improving efficiency seems to be working well, and helped to improve operating margins by 70 basis points in 2015 versus the prior year. And with an order backlog of $66.1 billion as of the end of 2015, the company offers a high degree of revenue visibility as well as improving free cash flow, which amounted to $1.9 billion for the 2015 fiscal year.
As such, it could be argued that with General Dynamics trading on a forward P/E ratio of 12.8 versus 16 for Lockheed Martin and 14 for Boeing, it's a stock worth buying at the moment. Similarly, its EV/EBITDA ratio of 8.8 is appealing on a stand-alone basis, as well as when compared to Lockheed Martin and Boeing, which have EV/EBITDA ratios of 12.8 and 9.5, respectively. In other words, General Dynamics may have less diversification than Boeing, but its lower valuation seems to factor this in and make it appealing on a relative basis. This view is strengthened by the fact that Lockheed Martin relies on the U.S. government for a greater proportion of its sales than is the case for General Dynamics, and yet Lockheed has a higher valuation.
While General Dynamics is less well-diversified when it comes to its customer base than would be considered optimal, its risk/reward ratio remains relatively favorable. With the company's range of divisions and products, as well as a strong order backlog, rising free cash flow, and increasing efficiencies, the stock seems to be worth considering as a buy rather than a sell.
Robert Stephens has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.