With the presidential candidates arguing over who can best protect the country at a time when terror risk is as high as ever, it's no wonder that Wall Street has been generally supportive of the defense sector. Indeed, given the market indices' poor performance so far this year, the more than 4% return on the Dow Jones Aerospace index looks good. General Dynamics ( GD), which is up more than 7% so far this year and more than 3% since I last
highlighted it in April, has fared even better than most. There's a reason for that: The company has consistently posted better-than-expected, high-quality earnings growth. It's likely to continue given the strong congressional support for many of its large defense programs and the inevitable recovery in its commercial aerospace business, Gulfstream. While the shares are no longer a deep bargain relative to other names in the group, trading at a P/E ratio of 15 times the consensus earnings estimate of $6.43 per share for 2005, that is still at the low end of the P/E valuation range of 15 to 18 for its defense company peers. General Dynamics' second quarter was even better than it appeared on the surface. The company reported earnings of $1.47 per share, ahead of the consensus estimate of $1.40, even though the numbers included 4 cents worth of unusual costs such as acquisition-related expenses and asset impairments. Sales grew double digits organically in all divisions except for Combat Systems, where sales were off 5% to 8% on a comparable basis due to the timing of deliveries of Stryker combat vehicles.
But the big story was with the company's operating margin, which jumped 80 basis points year over year to 10.4% and was up 50 basis points sequentially from the first quarter despite a similar sales level. On the company's second-quarter conference call, Chairman Nick Chabraja mainly credited the Information Systems unit for turning in a better-than-expected performance thanks to a smoother integration of last year's third-quarter acquisition of Veridian. Indeed, Information Systems' margin of 11.4%, while down from last year's pre-Veridian level of 12.2%, was up sequentially from 9.9% in the first quarter and well ahead of management's guidance of just 10%. And while the debate continues over whether growth in the defense budget is sustainable, the anecdotal evidence seems to support those in the camp who see no peak in spending before 2006. And within that favorable backdrop, General Dynamics appears to be grabbing its fair share of the pie. According to a report last week by Jeffries analyst Gary Liebowitz, the House-Senate conference committee approved a fiscal 2005 defense spending bill that includes $147.6 billion in military investments (the procurement and research, development, testing and evaluation accounts that are most important for contractors). That's at least several percentage points above the president's initial request in February. General Dynamics, Liebowitz wrote, seemed to benefit the most from the higher spending. For example, Congress seems ready to approve $625 million more for a seventh Stryker brigade. Chabraja said that the Stryker was doing well in Iraq and that Congress was likely to add even more to the program than General Dynamics had anticipated in its own internal plans.
Strong defense spending aside, General Dynamics may also be on the brink of seeing some good news come out of its Gulfstream business jet division. Even in the absence of a recovery in volumes, earnings are already improving dramatically thanks to cost cuts and the reduction in preowned aircraft losses. On an 8% increase in revenue, Gulfstream's operating profit more than doubled, as did the operating margin, which rose to 12.2% from 6.3% last year. Although there were no losses of used aircraft in the quarter, the company did sell four preowned jets at break-even, and Chabraja said that market has stabilized. More importantly, Chabraja said that demand for new aircraft is picking up. "New equipment orders could be super-heated in the third quarter. We're seeing a lot of activity," Chabraja said. Free cash flow was quite strong in the quarter, coming in at $296 million, or 100% of net income, and up $20 million from the first quarter. General Dynamics' balance sheet remained rock-solid at the end of the quarter, with $900 million in cash and a debt-to-capital ratio of 38.3%, roughly flat with the first quarter.
It has been a good year so far for defense contractors like General Dynamics. But while the stock may no longer be cheap compared to other defense stocks, solid support for General Dynamics' defense programs combined with a recovery at Gulfstream could help the shares continue to perform well the rest of this year.