General Dynamics: Undervalued And Cheap At Current Trading Levels (NYSE:GD)

General Dynamics (NYSE: GD) is a global leader in the aerospace and defense industry with an estimated 22% upside from current trading levels. The stock saw significant drawback during the height of the COVID pandemic where shares traded at a low of $106.60. At the time of writing, the stock has since rallied up to around $135 a share and I have priced in an estimated 22% upside, where shares could be priced at $170. I have priced in 14% downside risk where shares could trade around $120. Given the tight window in risk/return potential, I am bullish on the company, but also have tight stop loss levels to watch for.

Background

According to the company’s annual 10-K:

“General Dynamics is a global aerospace and defense company that offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; information technology (IT) services; command, control, communications, computers, intelligence, surveillance and reconnaissance (C4ISR) solutions; and shipbuilding and ship repair… Our company consists of 10 business units, which are organized into five operating segments: Aerospace, Combat Systems, Information Technology, Mission Systems and Marine Systems. We refer to the latter four segments collectively as our defense segments.”

Company/Industry Overview

GD operates within 10 business units and five operating segments, including Aerospace, Combat Systems, Information Technology, Mission Systems, and Marine Systems. The company is the fifth-largest defense contractor in the United States and sixth largest in the world by revenue.

Aerospace Segment

The company’s 10-K states:

“Our Aerospace segment is at the forefront of the business-jet industry. The segment consists of our Gulfstream and Jet Aviation business units… Jet Aviation has been a global leader in business-aviation services for over 50 years, providing comprehensive services and an extensive network of locations for aircraft owners and operators. With approximately 50 airport sites throughout North America, Europe, the Middle East and Asia Pacific.

The company’s goals for this segment include developing innovative first-to-market technologies/products and providing first-class customer services. In fiscal year 2019, the company expanded this segment through acquisitions and renovations of markets in Teterboro, Dallas, Scottsdale, San Juan, West Palm Beach, and the Middle East.”

Below is a breakdown of this segment’s revenue.

*Obtained from the company’s most recent 10-K.

Combat Systems Segment

The Combat Systems segment is extremely diverse and is a main revenue driver for the company. The company’s 10-K states:

“Our Combat Systems segment offers combat vehicles, weapons systems and munitions for the U.S. government and its non-U.S. partners. We are a platform solutions provider, offering market-leading design, development, production, modernization and sustainment services. With extensive and proven product lines, we deliver tailored solutions for diverse customer-mission needs. Our Combat Systems segment is well-positioned to serve the growing needs of its largest customer, the U.S. Army, as it increases the readiness of its current force and modernizes for the future, while at the same time meeting the growing international demand driven by the global threat environment.”

This segment has a few different sub-categories including “Wheeled and Combat Tactical Vehicles”, “Main Battle Tanks and Tracked Combat Vehicles”, and “Weapons Systems, Armament, and Munitions”.

Wheeled and Combat Tactical Vehicles:

With vehicles in over 20 countries, the Stryker vehicle line is the main product in this sub-category. These vehicles have eight wheels and are considered a medium-weight vehicle. According to the last 10-K, over 3,300 Stryker vehicles have been delivered to customers. There are currently 11 different variants of the Stryker vehicle and in 2018, the US Army made the decision to upgrade their fleet (nine total brigades) entirely to the A1 configuration (pictured below). GD is currently under contract to fulfill the remaining backlog of this order by 2021.

*Stryker A1 Configuration

The company also has a market-leading position in LAVs (Light Armored Vehicles) with approximately 13,000 total vehicles in service around the world. According to the most recent 10-K, GD is currently in the process of upgrading the Canadian Army’s fleet of LAVs, and in 2019, the company was awarded a contract for $1.3 billion to produce 360 of their vehicles, in eight variants, for the Canadian Army. The company is the primary provider for wheeled armored vehicles and logistics services for the Canadian Army through 2024.

Main Battle Tanks and Tracked Combat Vehicles:

The main vehicle in this sub-category is the Abrams main battle tank. GD is currently updating the US Army’s M1A2 Abrams tank with the SEPv3 package, which includes advancements in communication, power generation, fuel efficiency, and armor. The company was awarded a contract by the US Army for $714 million in 2019 to upgrade 174 of the tanks to the new package. GD is also upgrading the system further to the SEPv4 package. Further, GD is producing the AJAX, a medium-weight vehicle for the British Army. However, they are in the early stages of this process. They are currently transitioning from the engineering phase to the testing phase and they are expecting to be in full production by 2024.

*Abrams M1A2 Battle Tank

*British Army AJAX Tank

Weapons Systems, Armament, and Munitions:

This sub-category complements the vehicles by designing, developing, and producing a variety of advanced weapons. GD manufactures M2/M2-A1 heavy machine guns and MK19/MK47 grenade launchers. The company also produces weaponry for all US fighter aircraft, including the Joint Strike Fighter. In North America, the company has a market-leading position in the “supply of Hydra-70 rockets, large-caliber tank ammunition, medium-caliber ammunition, mortar and artillery projectiles, tactical missile aerostructures, high-performance warheads, military propellants, and conventional bombs and bomb cases” (10-K).

Below is a breakdown of the revenue for the Combat Systems Segment:

*Chart obtained from the company’s annual 10-K statement.

Information Technology Segment

GD states in their 10-K, “With a network of 90 global partners… Our Information Technology segment provides a wide spectrum of services and capabilities, including artificial intelligence, cloud computing, cyber, software development, systems engineering, IT modernization and data analytics”. This segment has three subcategories including “IT Services”, “IT Infrastructure Modernization”, and “Professional Services”.

IT Services:

GD offers a wide variety of products and services in this sub-category, including technology consulting, solution design, operation and maintenance, cloud services, and cyber defense systems. Specifically, GD provides cybersecurity services at the Pentagon which includes endpoint security, network security, and incident handling. In 2019, the company was awarded a $325 million contract from the Department of Homeland Security to provide priority telecommunications services to Cybersecurity and Infrastructure Security Agency’s Emergency Communications Division. Specifically, this allows the company to continue to provide emergency telecommunication services during natural disasters, acts of terrorism, and acts of war.

IT Infrastructure Modernization:

GD is currently working with the Department of Defense to migrate all of their applications to the could. The program, which is called milCloud 2.0, “provides a hybrid cloud solution designed specifically for the warfighter that offers ease of use, improved performance, enhanced security, and greater affordability” (10-K). In 2019, GD was selected by the Department of Health and Human Services to provide them with advanced technologies (A.I., machine learning, natural language processing, etc.) to support their workforce.

Professional Services:

The professional services sub-category includes logistics and supply chain management, training and simulation, and life science applications. In 2019, GD won a $2 billion contract with the US State Department to continue monitoring their global supply chain. This supply chain is crucial to delivering millions of assets to worldwide customers, some of which are in high-threat areas. In the defense portfolio of this service, the company offers training and simulation services for the US Army’s Aviation Center of Excellence in Fort Rucker, Alabama, which is the largest helicopter training program in the world.

Below is a breakdown of revenue for the IT segment:

*Created by the author using data gathered from the company’s annual 10-K statement.

Mission Systems Segment

The company’s 10-K states, “our Mission Systems segment is a global provider of mission-critical products and systems… The Mission Systems segment has more than 100 locations worldwide… we deliver innovative defense-electronics hardware and integrated systems as well as subcontract efforts in support of large-scale land, air, sea, and space platforms”. This segment is a leading manufacturer and integrator of tactical, secure communications systems for both US and non-US customers. GD operates three sub-categories in this segment, including “Ground Systems and Products”, “Space, Intelligence, and Cyber Systems”, and “Naval, Air, and Electronic Systems”.

Ground Systems and Products:

GD is the prime contractor for the US Army’s mobile communications system. This system provides secure voice, video, and data capabilities to soldiers on-the-move. In 2019, GD was awarded an indefinite-delivery, indefinite-quantity (IDIQ) contract to provide electronic and cyber warfare capabilities. These contracts have been increasingly popular among the US government over the years because it allows the government to have some flexibility with not knowing the exact time requirements or quantities needed for jobs. This is also beneficial to GD because it means that the government is not allowed to negotiate with other companies for the work being done. Thus, GD will be doing some or all of the work needed and that will be released once negotiations have finished.

Space, Intelligence, and Cyber Systems:

GD engineers in this sub-category work with payloads for advanced missions, build/manage ground-based communication systems, and provide mission data tracking for their customers. In 2019, GD was awarded a contract with the US Navy with a maximum potential contract value of $732 million to sustain the integrated ground systems for a narrowband satellite communication system.

Naval, Air, and Electronic Systems

GD has a long-lasting 50-year relationship with the US Navy for providing advanced fire-control systems for the submarine programs, both ballistic missile, and attack. In 2019, GD completed an overhaul of the over-the-horizon missile capability onto the USS Gabrielle Giffords (LCS 10). GD is also responsible for designing and manufacturing underwater vehicles for the US and non-US military customers. The company has manufactured over 100 sensors for their line of Bluefin Robotics underwater vehicles, which is an unmanned underwater vehicle. In addition, in 2019, the company’s Knifefish surface mine countermeasure vehicle received approval to enter low-rate production, which is beneficial to the Navy securing five of the systems (10 total vehicles).

Below is a breakdown of the revenue for the Mission Systems segment:

*Created by the author using data gathered from the company’s annual 10-K statement.

Marine Systems Segment

The Marine Systems Segment is another market-leading segment of the company. In this segment, GD designs and builds nuclear-powered submarines, surface combatants, and combat ships for the US Navy. The largest product category in this segment is the Electric Boat, which is the lead shipyard on all Navy nuclear-powered submarines. The US Navy procures these nuclear-powered submarines at a current rate of two per year. To date (from the company’s most recent 10-K), the company has delivered 18 submarines from the first three blocks of orders. There are also a combined 10 ships from the fourth block under contract and scheduled to be delivered through 2024. Further, in 2019, the Navy awarded GD with a record contract worth $22.2 billion for construction of the fifth block of eight nuclear-powered submarines. There is a stipulation to the contract that could pay out to a total of $24.1 billion if the US Navy decides they want to add a ninth and tenth submarine to the block.

Below is a breakdown of the revenue for the Marine Systems segment:

*Chart obtained from the company’s annual 10-K statement.

Economic Factors to Consider

Because of the nature of business GD engages in with both foreign and domestic government entities, it is important to consider economic factors that could have an impact on the company. First, it is important to analyze total US government spending to get a better idea of how much money is available for the defense industry in the budget. In the chart below, we can see that during President Obama’s second term, there was a drastic decrease in government spending, partly due to the 2008 financial crisis. Also, it is clear that President Trump has raised government spending back up to the highest they have been since around 2010.

*Chart obtained from the Trading Economics website analyzing US government spending over the last 25 years.

Another important economic factor to consider is the total government military spending. This figure shows individuals how much the government’s total budget is allocated toward military spending. Typically, the more money budgeted toward the military, the better GD can be expected to perform. Below is a chart showing total military spending from 2003-2019, with an estimated 2021 military spending budget.

*Chart obtained from an article posted by Kimberly Amadeo and Thomas J. Brock.

Customers

The company’s primary customer is the Department of Defense (DoD). Other major government entities that GD does business which includes the Department of Homeland Security and Health and Human Services. In 2019, government customers accounted for roughly 66% of total revenue for GD. The DoD makes up 77% of the total government customer revenue. This shows that GD relies heavily on the DoD to drive revenues moving forward and it is clear that any cut in defense spending will likely have a negative effect on GD.

Below is a chart showing the breakdown of government customer revenue:

*Chart obtained from the company’s annual 10-K statement.

Turning to commercial customers, these customers do not make up nearly as much of the overall revenue as the government customers. The company breaks down their commercial customer base into US and non-US customers.

Below are two charts showing the breakdown of revenues from 2017-2019:

*Both of the above charts were created by the author analyzing annual revenue from the company’s annual 10-K statement.

To show total annual revenue between 2018 and 2019, I have created a chart showing just how much GD relies on government spending to drive their revenue.

*Created by the author using data gathered from the company’s annual 10-K statement.

Competition/Market Share

GD competes in an extremely competitive market given they are constantly bidding for government contracts. In terms of the competition specifically in the defense market, GD competes against other major contractors, as well as smaller private companies that specialize in particular technology or capability. According to the company’s 10-K:

“Our Combat Systems segment competes with a large number of U.S. and non-U.S. businesses. Our Information Technology and Mission Systems segments compete with many companies, from large government contracting and commercial technology companies to small niche competitors with specialized technologies or expertise. Our Marine Systems segment has one primary competitor with which it also partners on the Virginia-class and Columbia-class submarine programs.”

The company also competes in the Business Jet-Aircraft market, but they believe they are positioned well to continue to be a market leader because of their Gulfstream products.

Various factors determine the company’s ability to remain competitive in each of their respective markets. However, one of the key factors is their ability to innovate and develop new products/technologies. Given the company’s proven ability to secure government contracts (as demonstrated above given the revenue breakdown), it is evident that they are able to innovate.

Valuation

I have created different models and examined different metrics to try to value GD effectively. The models I have created are a comps analysis, ratio analysis, full-projection model, “Basic Assumptions” model, Full-DCF model, Beta calculation, and I built a sensitivity analysis based off my results of these models. I also analyzed metrics such as ROA, ROE, EV/EBITDA, P/E ratio, etc. to try to get a better understanding of the company’s overall position in the market.

Comps Analysis

For my comps analysis, I compared GD to respective competitors Northrop Grumman (NOC) and Lockheed Martin (LMT). With relatively similar metrics, these companies are major competitors for GD. As shown below in my model, GD is trading at a discount, relative to both NOC and LMT. It is important to note, however, that GD is the smallest of these three companies in terms of market cap.

*Created by the author using data gathered from the company’s respective 10-Q statements.

Based on the above comps analysis model, it can be determined that GD is trading at a discount relative to both NOC and LMT. A potential cause of this is that the company is smaller in terms of market cap, so they will have relatively smaller multiples. However, I do think GD is trading at an undervalued price even though they are smaller than both of these competitors. Analyzing average metrics for these three companies, I determined a fair EV/EBITDA of 10.93x (pricing shares for GD at $159), a fair EV/EBIT of 13.34x (pricing shares at $200), and a fair P/E of 14.5x (pricing shares at $226). These metrics, when averaged into one intrinsic value for the stock, obtains a price target of $195, showing an undervaluation of roughly 44%.

Ratio Analysis

When building my ratio analysis, I am looking to determine a few specific metrics that a company has had over the last few years. Below is the model that I built:

*Created by the author using data gathered from the company’s annual 10-K statements.

This model is specifically built to analyze GD from 2017-2019. In this model, I analyze the growth/decline of EPS, ROS, ROE, ROA, P/E ratio, payout ratio, and dividend yield. Analyzing the results above, the company has a strong, consistent payout ratio of roughly 33%. This shows that the company is willing to pay investors a decent amount of their net income and that has also led to a decent dividend yield of roughly 2.30%. I believe, based on the above model, the company is in a solid position to continue providing quality shareholder value.

Basic Modeling Assumptions

My Basic Modeling Assumptions model has a few parts. First, I calculate the WACC (weighted average cost of capital) to use in my models. I then project the growth of different income statement and balance sheet items. After building a basic assumption income statement and balance sheet, I built my corporate valuation model and APV model. Below are the results of those two respective models:

*Created by the author using data gathered/projected from the company’s annual 10-K statement.

As can be seen above, these two models show that the average price target for GD is $169.65, signifying 23% upside potential from current trading levels. However, I also built a sensitivity analysis using a +/-10% forecast error with the data below to get a more defined look at the intrinsic value of GD shares:

*Sensitivity Analysis created by the author using Excel to project Bull/Bear Case price targets.

The above sensitivity analysis shows a very bull case price target of $210.30 and a bear case price target of only $131.06. The bull case is highly unlikely in the near term, but given the current stock price, the bear case level is very reasonable as a downside risk to a long-term investment in GD. As an even safer margin of error, my true downside risk is priced in at right around $121. Given the above models, I think the stock is truly undervalued and investors can expect the stock to rally toward my $170 price target.

Full-Projection Model

For the projection model I built out, I project the company’s three financial statements for the next five years. This model allows me to have a better understanding of growth trends and margins moving forward. Below is my model:

*Created by the author using data obtained from the company’s annual 10-K statement.

My projection model allows me to build out my DCF model. I use the projections in this model to build out the DCF model which leads me to an intrinsic value for the company. Below is the model I created:

*Created by the author using data gathered from the Full-Projection Model.

Based on this model, the intrinsic value for GD is $182.68. This price target was obtained using a calculated WACC of 7.38% and an estimated terminal growth rate of 4.75%. Below, I have created a sensitivity analysis to show price movements in the stock given an increase or decrease in WACC and terminal growth rate, respectively.

*Created by the author analyzing different growth rates and WACCs from DCF Model.

In green highlighted boxes, I have determined these numbers to fall into a bull trading range for GD ($130- $200), and in yellow highlighted boxes, I have determined these numbers to fall into a more bear trading range ($85-$129.99). Below is a basic summary of the above sensitivity analysis:

*Created by the author analyzing the data obtained from the DCF Sensitivity Analysis.

The “Low/High End of Price Range” is an average of the respective color highlighted boxes. Based on those averages, my DCF model is signifying roughly 32% to the upside and 24% to the downside.

Technical Indicators

Using the Fibonacci Retracement levels and the RSI technical indicators, I have been able to better interpret my extensive fundamental analysis. Looking at the below chart, I have put Fibonacci Retracement levels on the graph to get a better idea of strong support/resistance levels.

Fibonacci retracement levels typically act as support and/or resistance for a stock. As shown below, the horizontal lines (which are the retracement lines) show when possible trends could be setting up. For example, during the height of the COVID pandemic, on 3/23/2020, GD shares hit the 0.00% retracement level at $100.55. After those lows, the stock rallied nearly 67% to right around $165, seeing some minor resistance right below the 78.6% level, priced at $170.92. Today, GD has just seen a breakout trend setting up, as shares dipped below the 38.2% level for a few days and have just broken above. We also saw the RSI indicator touch the 30 level, indicating that shares were oversold.

However, we are getting close to a resistance level in terms of the RSI indicator at right around 55. Right now, the GD chart shows an RSI of about 46. As can be seen by my price level I drew on the graph, specifically the yellow highlighted circles, this level is key for GD. I believe my bull case will play out nicely if GD can break through this level to the upside and make a run toward my $170 price target. If resistance holds at this level and rejects a run to the upside, my prediction is that the RSI will get back down to 30 (as seen by the green highlighted circles) before testing another run. Thus, my bear case has priced this in, and I have included an ultimate bear case where shares could reach the 23.6% Fibonacci Retracement level, pricing shares around $121.

*Chart obtained from TD Ameritrade ThinkorSwim Platform with Technical Indicators put on by the author.

Final Price Target Recommendation

Using all of the data I have obtained and analyzed, below is my model for determining an intrinsic value for GD:

*Created by the author showing how the final price target recommendation was achieved.

The chart above pulls all of my intrinsic value calculations and is given a percentage weight, based on how much I deem that model to be respective of the overall stock value. I then multiply each intrinsic value by its respective weight and sum the numbers together to get the final price recommendation of $168.98, which I have simply rounded up to $170 for my price target. My price target of $170 signifies roughly 23% to the upside. I have also priced in a downside risk of 14.20%, where shares could fall to around $120 as a worst-case scenario.

Risks to Consider

One of the main risks to consider for an investment in GD is the government’s spending on the defense sector. Given the current political landscape, it is important to note that one of Joe Biden’s main concerns is the COVID pandemic. I am predicting that government spending will not change drastically in the near future given this fact. According to an article written by Joe Gould5, he states that some analysts expect “defense spending to be flat or down 4-8% over the next five years, depending on external political factors and the makeup of congress”. With the Republican party performing better than expected in the 2020 election, gaining seats in the House, and maintaining control of the Senate, I would predict that at most, we could see a cut of between 2-4% in defense spending. President Trump has significantly increased defense spending (as seen previously in the Economic Factors to Consider section). Because the company relies on government spending (in 2019, nearly 65% of revenue came from the government), any defense budget cut will likely have a negative effect on the company’s overall revenue. However, a predicted drawdown of 2-4% would be much more reasonable now, in my opinion, and GD would not be as adversely affected if there was an 8% drawdown.

Another major risk is that the US government has the right to terminate a contract, in full or in part, at their discretion. There are two main reasons the US government would terminate a contract. The first reason would be for convenience. In this case, the government would be responsible for covering any costs incurred by the contractor (per GD 10-K). However, the government may also terminate any contract due to a breach by the contractor. In this case, the government is only responsible for payment for any work they have accepted.

Conclusion

In conclusion, I’d like to emphasize my bullish sentiment on GD. I believe the company will continue being a leader in the aerospace/defense industry, which in turn will continue to drive their stock price higher. My price target is strong at $170, and I will put the downside risk price target at $120. I am projecting 22% to the upside and the potential for 14% to the downside from current trading levels.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.