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Neutral on General Dynamics

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We have maintained our Neutral recommendation on the defense major General Dynamics Corp. (GD - Free Report) on Sep 6, 2013.

Why the Reiteration?

General Dynamics is one of the largest U.S. defense contractors whose revenue exposure is spread over a broad portfolio of products and services that help it to keep the overall growth momentum steady. The company is one of the two contractors equipped to build nuclear-powered submarines in the U.S.

The company posted strong second-quarter results with the top and the bottom line easily surpassing the respective Zacks Consensus Estimate. Earnings were up year over year, while revenues showed a marginal decline of 0.1%. The results reflect a steady flow of orders and an efficient cash deployment strategy.

In order to counter the decline in revenues from European Land Systems, a unit of Combat Systems, General Dynamics is restructuring the business.  The restructuring plan would remove excess capacity and bring the size of its European business in line with future demand.

Again, General Dynamics has one of the strongest balance sheets among its peers. Management returns a substantial portion of its free cash flow to shareholders through share repurchases and incremental dividends. It repurchased 6.6 million shares in the second quarter, and still intends to deploy all of the free cash flow for dividends and buybacks this year. Earlier in the year, the company boosted its quarterly dividend by 10% to 56 cents per share, marking the 16th consecutive annual increase. This carries a dividend yield of 2.58%.

However, the threat of budget cuts from the Department of Defense (DoD) keeps us on the sidelines. A large percentage of General Dynamics’ business is generated from the U.S. DoD. Hence, cuts in defense spending could hinder growth in operating segments. The company has now factored in the impact of sequestration on Combat Systems revenues. For 2013, the company now expects revenues to decline 15% versus the earlier estimate of down 8%. In fact, the second-quarter performance was driven by stronger-than-expected margins from Aerospace, Combat and Marine. Hence, the scissor in the defense budget could adversely impact the Combat Systems segment, thereby rendering the company vulnerable at large.

Other Stocks to Consider

General Dynamics presently carries a Zacks Rank #3 (Hold). Other better-placed operators include Zacks Ranked #2 (Buy) Northrop Grumman Corp. (NOC - Free Report) , Lockheed Martin Corp.  (LMT - Free Report) and B/E Aerospace Inc. .

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