One of only two stocks added to the Dividend Aristocrats Index this year, General Dynamics is a case study for a stable dividend stock. Not only is this a new entrant to the index but it’s also the only one that’s part of the humongous aerospace and defense sector that ‘s managed to pay a consistent dividend for so long.
There’s no doubt this is massive leap from the beverage companies we’ve been discussing for the past few weeks. Here’s a deep dive into GD’s books:
GD was a supplier of tanks, rockets, missile, submarines and a wide range of other wartime defense products for the military. Steadily growing since 1952, General Dynamics is now one of the largest military and defense contractors in the world. The company’s operations are divided between four key business segments: Marine Systems, Combat Systems, Information Systems Technology, and Aerospace.
The company has essential grown through consolidation over the years. Steadily merging and acquiring companies in different fields has helped it gain momentum and scale over half a century. The company now sells everything from sophisticated surface vehicles to precision missile systems across the world. Perhaps their most recognizable product is the Gulfstream G500 private jets. If you’ve ever seen a wealthy character on screen in a Hollywood movie, chances are it was one of these luxury private jets.
Aerospace is the largest business segment, accounting for well over 40% of the company’s operating income. The United States government is the largest customer, accounting for 60% of revenue. Under normal circumstances, being so reliant on a single customer would have been bonkers. However, this is a unique industry going through a unique phase. Not only are defense contractors expected to have close ties to their federal government, but the new Trump-administration is likely to boost military spending disproportionately high over the next few years. After striking defense deals worth $110 billion in Saudi Arabia this past week, Trump has proven he’s the defense industry’s best salesman in history.
No doubt, GD stands to benefit from such relentless spending on defense and security.
Increasingly, the company is shifting focus to IT security systems. Cybersecurity is becoming more of a political and military threat which is why GD is taking the plunge into complex software and hardware solutions for military-grade security.
Based on market capitalization alone, GD is the fourth largest aerospace and defense company in America. The company is worth $42 billion while its closest competitors, The Boeing Company (BA), United Technologies (UTX), and Lockheed Martin (LMT) are all worth $78b, $74b, and $66b respectively.
There is long-term steady growth predicted for the market for the foreseeable future, according to a report by Deloitte. All regions are expected to expand their spend on defense systems and aircrafts (commercial or military) in the coming decades. Although the rate of growth is fairly subdued at low single-digits. South Korea, United Kingdom, United States, India, and the Middle East are considered the most attractive regions for American defense contractors. Even China increased its defense budget by 7% this year. These are perilous times with war raging in Syria, increasing tensions between the two Koreas, and a brewing war over the South China Sea. While a sudden outbreak of war is detrimental for the global economy, it’s unfortunately good for the defense sector.
The good thing about the defense sector is the long-term nature of their lucrative contracts. GD has an order backlog of over $85 billion which is nearly three times the revenue it earned in 2016.
The orders in backlog are spread out nearly evenly in all four sectors, with $13b for aerospace, 22b each for combat system and IT, and $26b for marine systems.
A key part of the business moat or competitive advantage is the company’s ability to deliver sophisticated weapons and invest in R&D for better defense products and intellectual property. Besides the Abrams and Stryker family of battle tanks, the company has a vast portfolio of complex and secretive weapons that are developed in-house and supplied to the country’s military.
The stable contracts ensure the sustainability of the business even when governments cut back on their defense spending. During the Global Financial Crisis of ‘08-’09, the government was too busy spending money on bailouts and propping up the financial system to bother with military spending. GD’s profits over the course of the crisis and during the following recession kept expanding at double digit percentages. In other words, the company makes money regardless of the state of the economy.
Considering the state of the industry and the size of its competitors, it’s surprising to learn that none of the other defense companies are on the Dividend Aristocrats Index. Goes to show how tightly the GD ship is run.
We’re back to applying the dividend discount model for this dividend aristocrat. To see if it’s worth buying despite the stock having tripled in the past decade.
So, here’s what we know about this stock’s dividend. Over the course of this year, the company will pay a dividend of $0.84 every quarter. Which means the dividend will add up to $3.36 over the course of twelve months.
The assumed growth rate in this dividend is the same as last year, 10.5%. However, we have assumed that the dividends will grow at a more reasonable 8% in perpetuity. The required rate of return on the stock, considering all its risks and cost of debt, could be close to 11%.
So, the dividend discount model for GD works out as follows:
Intrinsic Value = Dividend x (1+ growth rate)/ Required rate – Growth rate
= $3.36 x (1.08)/ 0.10 – 0.08
By this measure, the stocks seems overvalued. The stock is worth $121, while the market price right now is $200. This implies a 65% overvaluation.
GD is, no doubt, a well diversified company and a quality dividend paying stock. Its recent addition to the Dividend Aristocrats Index is indicative of the company’s ability to compound wealth.
Defense is also a significantly stable sector. Political upheaval and economic crises have no effect on the company’s earning power.
Nevertheless, the recent surge in stock price based on the growing enthusiasm for a defense spending boost by the Trump administration. This has made the stock overvalued. This is worth investment, just not at this price.