GD might be another smart value bet even though business travel has plunged

I started my market analysis this week by turning my focus to the Aerospace industry – which to the casual observer might seem pretty silly given the fact that, according to numbers cited this morning by the CEO of Boeing (BA), commercial air travel has plunged by -95% since COVID-19 has taken over the global consciousness. That should make the entire industry radioactive, right? Not necessarily – because another critical piece of this industry is Defense – which means long-term government contracts for a wide range of products and solutions for everything from jet fighters to tanks and submarines.

The Defense portion of this industry can also be volatile, because it is intrinsically tied to government spending, which can obviously ebb and flow with changes in political sentiment. That’s why many companies on this end of the business, like Raytheon (RTX) and General Dynamics Corp (GD) also put a lot of emphasis on business and commercial Aerospace; that usually acts as a useful counterbalance against variations in government spending.

The current world we’re living in has flipped that script. The pandemic has grounded air travel across the board, not just for popular commercial airlines, but also for all kinds of business travel, which is one of the reasons that before the market opened today GD’s earnings report showed a -24.5% decline over the last three months, driven largely by a decline in the Aerospace side (GD makes the popular Gulfstream jet). At the same time, management cited significant new defense contracts brought in during the quarter and that helped to buoy the business at large. Does that mean that GD, which touched a bear market low in March below $110, but has since rebounded to just below $140, could still offer some upside? Maybe – despite its rally in the last month, the stock is still more than -26% below its pre-pandemic peak at around $190. Are the fundamentals strong enough to still offer attractive upside despite the fact that Aerospace is still likely to keep seeing bearish pressure for the foreseeable future?

Fundamental and Value Profile

General Dynamics Corporation is a global aerospace and defense company. The Company offers a portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; information technology (IT) services and C4ISR (command, control, communications, computers, intelligence, surveillance and reconnaissance) solutions, and shipbuilding and ship repair. It operates through four business groups: Aerospace, Combat Systems, Information Systems and Technology, and Marine Systems. Its Aerospace group offers aircraft design; cockpit and cabin systems, and product service and support. Its Combat Systems group offers combat vehicles, weapons systems and munitions. The Information Systems and Technology group provides technologies, products and services in support of various programs. The Marine Systems group is a designer and builder of nuclear-powered submarines, surface combatants and auxiliary and combat-logistics ships. GD has a current market cap of $40.6 billion.

Earnings and Sales Growth: Based on this morning’s report, sales in the last quarter where -5% lower compared to the same quarter a year ago. Adjusted earnings in the last quarter were also -5% below the same quarter a year ago. Not surprisingly, GD saw its operating margin fall in the last year; in the same quarter of 2019, Net Income was 9% of Revenues, while in the last quarter it dropped to 5%.

Free Cash Flow: As of the end of 2019 GD’s Free Cash Flow is a little more than $1.9 billion. That translates to a modest Free Cash Flow Yield of 5.03%. This is a number that isn’t yet available for the most recent quarter, but it is reasonable to suggest this number should also decline given the drop in revenues, earnings, and Net Income.

Debt to Equity: GD saw long-term debt increase in the last quarter, from a little over $9 billion to $12.9 billion. At the same time, cash and liquid assets increased significantly, from $902 million to more than $5 billion. Servicing their debt is no problem, but continued declines in Net Income could put pressure on the company’s liquidity.

Dividend: GD pays an annual dividend of $4.40 per share, which at its current price translates to a dividend yield of about 3.22%. Even at that attractive level, GD’s dividend payout is also less than 50% of the stock’s earnings per share over the last twelve months – a conservative figure that actually helps bolster the company’s balance sheet strength.

Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but I like to work with a combination of Price/Book and Price/Cash Flow analysis. Together, these measurements provide a long-term, fair value target around $193 per share. That means that GD is significantly undervalued, with about 42% upside from its current price.

Technical Profile

Here’s a look at the stock’s latest technical chart.

Current Price Action/Trends and Pivots: The red diagonal line defines the stock’s downward trend from May 2018 to its low point in March at around $100. It also provides the baseline for the Fibonacci retracement lines on the right side of the chart. From that point, GD has seen a sizable rally in price, with the stock pressing close to resistance around $142, where the 38.2% retracement line sits, with support at about $129 based on the stock’s last pivot low. A break above $142 should give the stock good short-term momentum to continue the current upward trend and rally to about $155, where the 50% retracement line rests. If, however bearish momentum comes back to play and pushed the stock below $129, the stock could fall to about $125 in short order, with even more downside to about $110 very possible.

Near-term Keys: GD’s fundamentals are strong, despite the sizable headwinds in its Aerospace business. I also really like their value proposition, but don’t ignore the stock’s exposure to broad market-based volatility right now; a resumption of the broad market’s bearish momentum could kill GD’s current, impressive rally in short order, so you need to be willing accept some volatility right now to take a long-term position. If you prefer to work with short-term strategies, start by looking for a break above $142 as a signal to buy the stock or work with call options, using $155 as a useful profit target. If the stock drops below $129, consider shorting the stock or working with put options, with $125 acting as an attractive, quick hit exit target on a bearish trade, or possibly looking to $110 if bearish momentum accelerates.