America's victory over Saddam Hussein in Operation Desert Storm was a masterpiece of misdirection. Faced with an entrenched opposition, the U.S. Army sent thousands of Abrams tanks and Bradley APCs built by General Dynamics (NYSE: GD) on an end run past the enemy, attacking where no one was looking. This morning's earnings report from General D isn't quite as deceptive as Desert Storm was, but it's not what it appears to be, either.
Scanning the headlines, or watching as the stock ticker glows green, you might think General D enjoyed a fine quarter in the second quarter. Companywide operating margins widened an impressive 50 basis points. Unlike Boeing (NYSE: BA), which also reported this morning, profits expanded as a result. In imitation of Lockheed Martin (NYSE: LMT), General D upped its guidance for the year, something fellow defense stalwart L-3 (NYSE: LLL) failed to do. (We'll see how Northrop Grumman fares tomorrow.) Management says General D should earn at least $6.60 per share by year's end.
As a result, a stock that looks for all the world like a perfect "10" today -- 10 times earnings, 10 times free cash flow, and a combination of dividend yield and earnings growth that adds up to about 10% -- could in fact turn out to be cheap by the time the calendar flips over to 2011.
Or not. Fact is, I detect a couple of chinks in the company's armor-plated valuation. If you own General D today, or contemplate doing so soon, you'd be well-advised to keep an eye on the following chinks.
Free cash flow, divergent
Viewed from a trailing-12-month perspective, General D's free cash flow (FCF) almost perfectly mimics reported net earnings. Both numbers come to $2.3 billion and change, but in recent months, and last quarter in particular, they've begun to diverge. Q2's $414 million in free cash flow amounted to less than two-thirds of reported "profit."
Revenue growth, grounded
I also see risk in where the company finds its profits. While overall sales held steady in Q2, sales slipped slightly in the General's most high-margin segment, aerospace. Meanwhile, General D leaned heavily on the segment with its second-to-worst margins, information systems and technology, to shore up those lost revenues.
Worrisome trends? No doubt, but rest assured. With General Dynamics an official recommendation of Motley Fool Inside Value, you can be certain we'll keep a close eye on where these numbers are heading. Unlike our old friend Saddam, we don't intend to be taken by surprise.
