General Dynamics Continues to Generate Excess Returns as it Grows via the CSRA Acquisition

Chris Higgins
Senior Equity Analyst

The Nov. 6 midterm election results saw the Democrats taking over the House of Representatives, while the Republicans retained the Senate. House Armed Services Committee ranking member Rep. Adam Smith will now assume the chairmanship, while Rep. Pete Visclosky will take over as defense appropriations subcommittee chairman. We anticipate both will try to ramp up scrutiny of Department of Defense nuclear modernization, specifically the B-21 bomber (Northrop Grumman) and the Columbia submarine (General Dynamics). We also think the duo will increase oversight of overseas contingency operations spending. That said, Smith’s district is in the Puget Sound region, and we believe he will be an advocate for Boeing's programs relative to other priorities.

Our bull case envisions bipartisanship and an avoidance of gridlock, which creates funding certainty for defense names, but our bear case anticipates budget chaos and sequestration for fiscal 2020. Our base case entails a muddle through in which a 2020 continuing resolution, which freezes funding at the previous year's levels, occurs but an agreement to avoid budget caps is eventually struck. Flying under investors' radar is the likely resignation of Defense Secretary James Mattis. Depending on who replaces Mattis and when, we think the Pentagon might be at a disadvantage as it battles for its piece of the fiscal 2020 appropriations.

Although we continue to forecast accelerating growth for the U.S. defense majors through the first half of 2019 as outlays ramp, thanks to previous budget increases, our projection for modest growth in the fiscal 2020 defense budget is now on shakier ground. However, any decrease or flattening of defense budget authority won't be felt until later in calendar 2020. We are maintaining our fair value estimates for the defense companies we cover, and wide-moat names General Dynamics, Northrop, Raytheon, and Lockheed Martin are all trading at slight discounts to our valuations.

Business Strategy and Outlook 2018/10/24

Following the acquisition of CSRA, which closed during the second quarter of 2018, General Dynamics will operate five segments: aerospace (24% of pro forma 2018 sales), combat systems (16%), marine systems (23%), information technology (25%), and mission systems (12%). The CSRA deal roughly doubles the size of its existing IT business currently housed in IS&T. As a result, it's now one of the largest IT contractors for the U.S. government.

The aerospace segment, which operates Gulfstream business jets, enjoys a commanding position in the high end of the business jet market and is well-positioned to continue leading the market given Bombardier's challenges and the recent cancellation of Dassault's Falcon 5X jet. We think Gulfstream business jet deliveries have found a bottom and the aerospace segment will begin growing again. Its 2,000-plus fleet of aircraft will also provide recurring services revenue, and the 2018 acquisition of Hawker Pacific by the company's Jet Aviation subsidiary is further building out services capabilities. Although business jet margins will contract in 2018, we're convinced that the firm can maintain industry-leading margins even as it transitions to the new G500 and G600 jets.

General Dynamics' ground vehicle business, combat systems, is poised for significant revenue increases thanks to international work. In addition, the U.S. defense budget is returning to growth, and we believe that the U.S. Army will begin a long delayed vehicle modernization program. Marine systems operates in a duopoly for large U.S. Navy ships and submarines and the Columbia program should drive growth, while also providing near-term cash flows thanks to customer advances.

GD's entrenched competitive position in shipbuilding and ground combat vehicles, coupled with its industry-leading business jet brand, Gulfstream, will generate both top- and bottom-line growth for this wide-moat company over the long-term. Moreover, we continue to appreciate management’s focus on operational efficiency. That said, we are a bit concerned about the CSRA deal, given that it channels resources into a lower-margin, lower-growth area of the portfolio.


Incumbency and technological know-how have allowed General Dynamics to consistently generate returns well above its cost of capital. The 17% average return on invested capital from 2009 to 2017 was well above its cost of capital and supports our wide moat rating. This period included a 25% reduction in U.S. defense spending from 2008 to 2015 and a downturn in the business jet market where total deliveries in the market went from 1,315 jets in 2008 to 696 jets in 2011. General Dynamics derives its wide moat from intangible assets, efficient scale, and switching costs. Below, we outline the sources of moat for each segment General Dynamics operates.

The aerospace systems segment, which conducts most of its business under the Gulfstream brand, possesses a wide moat thanks to intangible assets and high customer switching costs. The segment, which accounts for just under 30% of revenue and about 40% of profits, boasts industry-leading profitability, with operating margins averaging 18.6% from 2013 to 2017 compared with an average operating margin well below 10% over the same period for Bombardier, Textron Aviation (Cessna), and Dassault. Furthermore, the aerospace business continues to dominate the large-cabin business jet space, which requires a higher degree of technical know-how and where customers demand performance. The presence of eight firms competing in medium and light business aircraft, compared with only three in the large segment, underscores this point, as does the G650's dominance of the ultra-long-range segment.

In 2017, Gulfstream delivered 120 aircraft (90 large cabin and 30 midsize), making it the largest player among large-cabin manufacturers. Gulfstream's leading market share emanates primarily from Gulfstream's solid brand and strong technical know-how, resulting in higher performance and higher-quality products. For example, the company made revolutionary use of bonded skins to create a fuselage on the G650 that can withstand higher air pressure, giving the G650 a lower, more comfortable cabin altitude. In addition, General Dynamics' expansive global service network, which is operated under the Jet Aviation subsidiary, enables the company to consistently rank at the top of business aircraft customer surveys in terms of operational support. The addition of the Hawker Pacific business builds out the company's services footprint in the Asia-Pacific region and increases the number of forward operating bases to 28 from 23. The high level of service Jet Aviation and Gulfstream offer customers, along with their geographic reach and the Gulfstream luxury brand, further bolsters General Dynamics' wide moat.

The marine systems segment, which accounts for around one fourth of revenue, enjoys a wide moat due to its duopoly position in submarines and warships, which emanates from efficient scale. Demand from the U.S. Navy fell precipitously after the Cold War, and commercial shipbuilding in the U.S. continues to struggle--fewer than half of the commercial yards that were active in the late 1970s and early 1980s are open today. As a result, the U.S. Navy acts as the primary customer for the five major shipyards supplying the government, all of which are operated by two companies, General Dynamics and Huntington Ingalls Industries. Moreover, only two yards--General Dynamics' Electric Boat and Huntington’s Newport News Shipbuilding--can produce nuclear-powered ships like the replacement for the Ohio-class submarines. We've also seen decreasing demand in this market--during the first half of the 1980s, the U.S. Navy regularly built more than 20 ships and subs per year, but current production rates now hover around just 10 ships and subs annually.

Furthermore, the increasingly complex ships being built with all-electric propulsion, stealth characteristics, electromagnetic catapults, and advanced weapon systems require significant technical know-how and investment. While we've seen some more competition in the lower-end of the shipbuilding market (for example, the Navy's Littoral Combat Ship program), nuclear powered submarines and destroyers, which are the market segments GD addresses, hasn't witnessed any new entrants over the past two decades. We conclude that this small, technically demanding market is not subject to true competition. Indeed, in 2002 the U.S. Navy signed an agreement, which was reaffirmed in 2009, with the major shipbuilders that effectively guaranteed workshare on programs. These dynamics suggest to us that no competitors will enter shipbuilding within the U.S. since entry would require heavy up-front investment and cause returns to fall below the cost of capital. GD benefits from this efficient scale, resulting in solid returns on invested capital across its shipyards.

The company’s combat systems segment enjoys intangible assets via its knowledge of the arcane and Byzantine contracting rules governing international and domestic defense procurement, which provides the segment with a narrow economic moat. For example, large U.S. defense contractors like General Dynamics are governed by special cost accounting standards that can be complex and difficult to comply with consistently. Similarly, U.S. defense customers are typically conservative in their buying patterns and hesitant to switch to new contractors, particularly for mission-critical systems like combat vehicles and munitions that combat systems has produced for decades. Furthermore, international defense deals are subject to numerous regulations on technology transfer (for example, the International Traffic in Arms Regulations), and these international contracts often work their way through the Foreign Military Sales program, which proceeds like a U.S. defense contract but has many unique features.

We assign General Dynamics' IS&T segment with a narrow moat, but the business effectively splits its revenue between a no-moat IT services business line and a narrow-moat Communications, Computers, Command & Control Surveillance and Reconnaissance, or C4ISR, business line. The former primarily conducts lower-end IT services including building and operating IT networks and systems for the Department of Defense and other U.S. government agencies. This business has been combined with the CSRA acquisition to create a $10 billion IT services powerhouse, sitting in second place in the market just behind Leidos.

The C4ISR business line has been extracted from IS&T post-CSRA deal closure, and it is now called mission systems. We believe this segment possesses a narrow economic moat due to its focus on higher-end, mission-critical technologies such as mobile communications on the battlefield, soldier satellite links, tactical radios, and command and control systems onboard ships and aircraft. These products require significant technical know-how in the form of intangible assets and also enjoy customer switching costs, since the Department of Defense and its armed services would be unable to perform critical missions if there were quality problems or product failures.

Fair Value and Profit Drivers 2018/10/24

We have decreased our fair value for General Dynamics to $216 per share from $220. The decrease in our fair value was driven by a reduction in our 2018 and 2019 estimates for the company's Aerospace and Marine Systems businesses. Both operating businesses turned in lackluster third-quarter performance, and we think that growth will now come in a bit lower than we were anticipating. At the same time, we're concerned that the Aerospace business may face a bit more margin pressure than we originally anticipated as it ramps up the new G500 and G600 aircraft programs. We include the $9.7 billion CSRA acquisition, which closed in early April 2018, in our model. Management anticipates gross synergies (prior to cost savings sharing with the U.S. government) from the combination of CSRA with its IT business to land at roughly 2% of the revenue in its new GD-IT operating segment. If these synergies are achieved, then this deal looks value-accretive in our DCF model. If the firm can't deliver, then the deal looks value-neutral at best. Given management's strong track record of creating value, we are giving it credit for most (but not all) of its forecast synergies. General Dynamics recently rolled out the revenue recognition standard that decreased both revenue and operating profits. Our model implements this new standard from the beginning of 2016 onward. We expect the firm to grow at an average annual rate of 8% from 2018-22, including the CSRA deal. General Dynamics' organic growth, which controls for the CSRA acquisition, is closer to 5% over this time period. Operating margins will come under pressure due to the incorporation of CSRA, which will create amortization expenses; CSRA also has operating margins about 100 basis points below General Dynamics' consolidated margins but its services business generally features lower invested capital. In addition, the transition to new products in business jets will weigh on margins, starting with the G500 ramp-up in late 2018. As a result, we're calling for consolidated General Dynamics operating margins (including CSRA) to average about 12.5% over our forecast period of 2018-22. We set midcycle margins, which begin in 2022, at just under 13%. Operating cash flows should land at $4.7 billion in 2019--the first full year CSRA is included in financials. We anticipate operating cash flows hovering at or just below $5 billion after 2019. We model capital expenditures at roughly 2.2% of sales each year from 2018 to 2022.

Risk and Uncertainty 2018/10/24

General Dynamics faces political uncertainty because of a defense procurement process that is lengthy and politicized, which can swing with the priorities of the administration in power. Also, program funding is reviewed each year by Congress, which exposes General Dynamics to the vagaries of the budgeting process. For example, the Columbia class submarine program, which requires about $80 billion of funding, may face battles in Congress as it annually competes for dollars with other defense programs.

Defense projects and the development of new business jets entail significant execution risk because of technical challenges during development and manufacturing, which can lead to cost overruns and lower-than-expected profitability. Although the U.S. Department of Defense underwrites most of development on new programs via cost-plus contracts, recent changes in its approach to contracting, particularly in shipbuilding, have introduced more contractor risk sharing.

Government contracting approaches affect defense industry profitability. In the 1960s, heavy use of cost-plus contracts during the preceding decade led to fixed-price development contracts. The result was several contractors nearly going bankrupt. A similar story played out in the latter half of the 1980s. In 2007, Congress made fixed-price contracts the standard unless the contracting agency could justify cost-based contracting. Thus, cost overruns remain a headline risk that could affect profitability through stricter contracting.

Stewardship 2018/10/24

We assign General Dynamics an Exemplary stewardship rating. We appreciate its management team, which remains focused on costs and squeezing efficiencies out of the company's businesses. Under Phebe Novakovic, who took the positions of CEO and chairwoman in January 2013, the company refocused its efforts on its operations. Novakovic's operational focus improved operating margins to over 13% in 2016 and 2017 from 11.7% in 2011.

The skill of this management team also shines through when we examine its stewardship of shareholder capital. The company is a dividend aristocrat, and we also like that management doesn't commit to hard share-buyback targets like several of its peers, instead opportunistically deploying capital to benefit shareholders. Over the past three years, GD has returned nearly $10 billion to shareholders in the form of dividends and buybacks, and dividends have grown to $3.36 per share from $0.88 in 2006.

We like GD's decentralized structure. Fewer than 150 employees work at its headquarters and management emphasizes empowerment of its business units, while holding them accountable to financial targets. These targets not only include income statement items but also incorporate cash and capital efficiency via ROIC.

All that said, the $9.7 billion CSRA deal does give us some concerns. With the acquisition, General Dynamics is channeling investment into one of its slower growing and lower margin businesses. Although we think management had to make an acquisition in IT services in order to remain competitive in a consolidating market, we were surprised by the scale of the deal and thought that a divestment of the company's IT business was the most likely move. If the firm can extract the promised synergies (2% of combined revenue), then the deal looks value-accretive in our DCF model. If it can't deliver, then the deal looks value-neutral at best.

Falls Church, Virginia-based General Dynamics manufactures submarines, armored vehicles, information technology systems, and business jets. It operates its businesses in decentralized manner, and following the acquisition of CSRA, which closed during the second quarter of 2018, General Dynamics operates five segments: aerospace (24% of pro forma sales), combat systems (16%), marine systems (23%), information technology (25%), and mission systems (12%). Based on the new revenue recognition standard, the firm generated $30.9 billion in 2017 sales.