General Dynamics: G700 Certification Delayed, But On The Way – ‘Strong Buy’ (NYSE:GD)

General Dynamics (NYSE:GD) is an aerospace and defense company that generates more than 70% of its revenue from the U.S. government. It has a steady growth record with a stable and quite healthy backlog. I forecast that the company will benefit from the increasing tension in the global geopolitical situation. The company reported its Q4 FY23 results on January 24th, exceeding revenue expectations. I am initiating coverage with a ‘Strong Buy’ recommendation and a fair value of $305 per share.

Strong Backlog Growth Amid Global Geopolitical Tensions

GD’s aerospace and defense businesses are benefiting from increasing geopolitical tensions globally. For instance, due to the Russia-Ukraine war, they have witnessed a rise in demand for combat vehicles in Europe. According to the Department of Defense, they increased the budget for Ukraine by $6.5 billion in 2022. While it is unfortunate to witness regional wars, these conflicts and potential geopolitical tensions are proving advantageous for GD’s business.

As illustrated in the chart below, the Department of Defense budget indicates a 2.7% compound annual growth rate during the period from FY21 to FY27. This stable budget growth provides a solid foundation for GD’s revenue growth over the next few years. Additionally, considering the current global conflicts, it seems unlikely that these uncertainties will improve anytime soon, leading to a potential increase in defense and aerospace spending globally.

Thanks to the steadily growing defense budget, GD has achieved stable earnings growth over the past five years, as illustrated in the table below. Their margin is currently standing at around 10%, which is in line with other defense companies. The company allocates most of its free cash flow towards dividends and share repurchases, reflecting a robust capital allocation strategy. Additionally, GD maintains a solid balance sheet, with a net debt leverage of 1.4x.

G700 Certification and Delivery are On the Way

GD had anticipated completing the certification for their Gulfstream G700 by the end of 2023, with G800 certification expected six to nine months after the G700. The company is required to wait for certification before delivering any aircraft to customers. However, the G700 certification faced delays in FY23, resulting in 15 G700 aircraft that couldn’t be delivered as initially planned.

During the earnings call, GD’s management mentioned that they are nearing completion of the final technical inspection authorization, FAA function and reliability flight test, and all associated paperwork. Simultaneously, they are encouraging customers to schedule pre-delivery inspections. While the delay in G700 certification may have impacted FY23 earnings growth, the deliveries are expected to shift into FY24, and it is unlikely to pose significant issues for the company.

Recent Result and FY24 Outlook

In Q4 FY23, GD achieved 7.5% revenue growth and 5% operating profit growth, with the backlog increasing by 2.7% year-over-year. Despite the G700 certification delay, the company generated $3.8 billion in free cash flow for the year, representing a robust cash conversion rate of 115%. In Q4, they paid out $360 million in dividends and did not repurchase any stock.

On the balance sheet, GD concluded the period with $1.9 billion in cash and equivalents, coupled with a net debt balance of $7.3 billion. This reflects a solid financial position, with a net debt leverage of only 1.4x.

For FY24, GD anticipates capital expenditure to range between 2% and 2.5% of sales, gradually approaching 2% thereafter. They have provided robust guidance for revenue and margin growth in FY24, projecting 9.5% revenue growth and a 100 basis points margin expansion. The primary growth driver is expected to be their aerospace business, with Gulfstream deliveries anticipated to increase from 111 in FY23 to 160 in the coming year, resulting in a 40% year-over-year growth in their aerospace business.

The FY24 guidance appears sensible, considering the G700 delivery delays from FY23. Initially, GD expected G700 certification by the end of the prior fiscal year, but 15 G700 deliveries were postponed, impacting FY23 results. As discussed earlier, management expresses confidence in completing G700 certification soon, making it a major growth driver for FY24 topline expansion.

Furthermore, during the earnings call, it was highlighted that the G700 is margin accretive for the company, which reinforces the expectation that the growth in G700 deliveries will drive margin expansion in FY24.

CSRA Acquisition Strengthens IT Solutions Business

GD completed its acquisition of CSRA valued at $9.7 billion in April 2018. This strategic move aimed to enhance GD’s high-tech IT solutions in the government IT market, with CSRA providing critical services such as cyber security, data analytics, and other IT services to the U.S. government.

The acquisition is viewed as value accretive for investors, given the complementary nature of the two companies’ services and their ability to cross-sell IT solutions to the same government customers. Both GD and CSRA serve the U.S. government, and the collaboration allows them to leverage their combined salesforce effectively.

The focus on key areas such as cyber security and data analytics aligns well with the U.S. government’s IT spending priorities. According to the White House, a significant portion (45%) of federal civilian IT spending is allocated to IT infrastructure, security, and management. Given the heightened importance of cyber security in government IT investments, the combination of GD and CSRA’s IT solutions is expected to contribute to continued notable growth.

GD’s management has noted particular strengths in the defense and federal civilian portfolios, citing investments in technology accelerators and capabilities like zero trust, artificial intelligence, digital engineering, and 5G. These investments align with customer demands and contribute to the success and resonance of the combined IT solutions offered by GD and CSRA.

Valuation

As discussed previously, I expect the completion of their G700 certification soon. The additional deliveries resulting from this certification are anticipated to contribute to additional revenue growth for GD. My assumptions for FY24 are in line with the company’s guidance. For normalized growth, I assume 5% organic revenue growth and 0.3% acquisition growth, consistent with their historical average growth.

I anticipate the company to gradually expand its operating margin over time, driven by the introduction of new products with higher margins. However, considering that the U.S. government is the primary customer, I don’t expect a meaningful margin expansion for the company. The government is quite sensitive to pricing and supplier margins. In the model, I only assume a modest 10 bps annual margin expansion.

The model employs a 10% discount rate, which is consistent across all my models. The assumed terminal growth rate is 4%, reflecting the expectation that defense spending tends to be higher than the overall GDP growth rate. The estimated fair value stands at $305 per share. Notably, the current stock price is trading at only 18 times their free cash flow, leading me to believe that their valuation is quite favorable and inexpensive.

Key Risks

Supply chain challenges in aerospace: GD has been grappling with supply chain challenges in their aerospace division. However, they have noted gradual improvements in FY23 and anticipate the complete resolution of these supply chain-related issues by FY24. The expected improvement in the supply chain is likely to have positive effects on their delivery cycle and revenue recognition.

Combat Leadership Change: On January 5th, 2024, GD announced that Mark Roualet, the current executive vice president of Combat Systems, will retire in April 2024. His successor will be Danny Deep, who currently holds the position of president of General Dynamics Land Systems. It’s noteworthy and positive to observe that the company has chosen an internal candidate as the new leader.

Conclusion

GD is well-suited for value investors seeking steady earnings and low volatility. I am initiating a ‘Strong Buy’ recommendation with a fair value of $305 per share.