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On Jul 2, 2013 we have upgraded our recommendation on one of the major defense contractors General Dynamics Corp. (GD - Analyst Report) to Neutral from Underperform.

Why the Upgrade?

General Dynamics engages in mission-critical information systems and technologies; land and expeditionary combat vehicles, armaments and munitions; shipbuilding and marine systems; and business aviation.

Even though the defense major reiterated its 2013 earnings guidance on flattish revenues, its first quarter results reflect some positive trends. Jet sales at the Gulfstream business are continuing to see traction even in the slowing defense sales scenario. The $60 million top-of-the-line G650 large cabin business jet is in high demand, with orders booked for the next five years. Gulfstream is expected to contribute more significantly to General Dynamics’ earnings going forward.

General Dynamics has rewarded shareholders by returning a substantial portion of its free cash flow through share repurchases and incremental dividends over the years. During the last reported quarter, it has also boosted shareholder wealth via $70 million worth of buybacks and a 10% dividend hike. This dividend hike marks the 16th consecutive annual increase and has a dividend yield of 2.80%. Its practice of raising dividends consistently will benefit the stock and attract investor attention.

Although we remain a little apprehensive over its declining backlog, which witnessed a 5.5% sequential as well as 12.3% year over year fall during the first quarter, the company managed to clinch quite a few significant contracts in the recent past. On Jun 4, 2013, General Dynamics won a contract, worth $2.84 billion, from the Department of Defense (DoD) and the U.S. Navy to construct four Arleigh Burke-class destroyers.

With respect to the present valuation, General Dynamics also looks attractive. The forward price/earnings (P/E) multiple of 11.8x is lower than the peer group average of 14.7x, reflecting a discount of 19.7%. The price/book (P/B) multiple of 2.4x is also lower than the peer group average of 3.1x. In addition, the company’s operational efficacy is apparent in its Return on Investment (ROI) of 14.2%, which is higher than the peer group average of 12.5%.

Other Stocks to Consider

General Dynamics currently retains a Zacks Rank #3 (Hold). Other stocks from the sector that are presently performing well include Embraer SA (ERJ - Analyst Report), The Boeing Company (BA - Analyst Report) and Northrop Grumman Corp. (NOC - Analyst Report), all with a Zacks Rank #2 (Buy).

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