Undervalued Dividend Growth Stock of the Week: General Dynamics Corporation (GD)

I’m sometimes asked what I love most about being retired really early in life.

Like many things in this life, people imagine something more glamorous than the reality.

That’s okay, though. Financial independence is truly wonderful. And if that mirage of glamour motivates people, more power to them.

However, most of the things I love most about being financially independent and retired early are the really small things.

And these small things all have something in common: they share a very important ingredient.

That ingredient is time.

It’s freedom.

It’s autonomy, independence, and complete flexibility.

For me, FIRE is all about doing what you want, when you want, where you want, with whom you want.

But if you don’t own your own time, you can’t set your life up like that.

Well, that’s why it’s so important to live below your means and intelligently invest your capital, as I discussed in the Early Retirement Blueprint – a step-by-step guide that can guide almost anyone to their early retirement dreams.

Of course, if you don’t have a job and the associated paycheck, you’ll need to have some kind of other source of income coming in so that you can quit the job and still pay your bills.

Well, that’s why the Blueprint’s foundation is built upon a very simple and straightforward investment strategy that solves this problem.

Enter dividend growth investing.

With DGI, you’re simply buying up shares in high-quality, world-class businesses that are so good at routinely increasing their profit, they end up with more money than they can efficiently use for the business.

This can lead to paying the shareholders (who are the rightful owners of a publicly traded company) a portion of that increasing profit.

That payment of profit usually comes in the form of cash dividend payments.

And as the profit grows, so should (and does) the dividend payments.

Jason Fieber's Dividend Growth PortfolioBuild up enough growing dividend income, you can quit your job and live off of your dividends.

That’s what I did, as I spent six years of my life aggressively saving and investing my way toward building my FIRE Fund – my six-figure dividend growth stock portfolio that generates the five-figure and growing passive dividend income I need to live off of.

That Fund was built on the tenets of DGI, and it’s comprised of some of the best dividend growth stocks out there.

A resource I continually used as I built that portfolio out is the Dividend Champions, Contenders, and Challengers list, which is a phenomenal resource that contains invaluable data on almost 900 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.

As great as this strategy is, though, one has to be cautious and intelligent about it.

You have to analyze businesses and carefully look at fundamentals, competitive advantages, and risks.

Perhaps most importantly, you also have to be able to reasonably estimate intrinsic value.

Understanding the difference between price and value is paramount to an investor’s long-term success.

Price is what a stock costs, but value is what a stock is worth.

It’s important to understand and take advantage of this distinction.

And I’ll tell you why.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk. 

That’s all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

The higher yield comes about due to the way price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield goes on to benefit total return because total return is made up of two components: investment income (dividends or distributions) and capital gain.

The former is given a boost via the higher yield (which translates into more dividends or distributions on the same dollar invested).

So that leads to greater long-term total return potential right off the bat, and that’s before factoring in the excess capital gain that’s possible from the “upside” that exists when you pay a price well below value.

While the market isn’t necessarily accurate at pricing stocks (leading to these very opportunities), price and value do tend to roughly track each other over the long run.

If you can buy in when there’s a disconnect between price and value, you give yourself some big upside there.

And that’s on top of whatever capital gain would naturally be possible as a business becomes worth more as it sells more products and/or services, increasing its profit (and value) in the process.

This should all lead to reduced risk, too.

It’s obviously less risky to pay less (versus more) for the same exact asset.

And undervaluation should allow one to build in a margin of safety, which protects you against unforeseen circumstances that can impair the value of the investment.

These concepts seem pretty easy to grasp, but it’s hard to spot and take advantage of undervaluation in the present moment.

Fortunately, fellow contributor Dave Van Knapp has made that process much easier via his piece on valuation, which is part of an overarching series of articles (or “lessons”) on the strategy of dividend growth investing.

You can check it out by reading Lesson 11: Valuation.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

General Dynamics Corporation (GD)

General Dynamics Corporation (GD) is a global aerospace and defense company.

As one of the world’s largest defense contractors, as well as the one of the largest manufacturers of corporate jets, General Dynamics operates across diverse and entrenched business lines that are hard to encroach on due to the massive scale and specialization that’s necessary to successfully manufacture and sell these products.

You hear about tech and social media companies starting up in a garage or a dorm room.

Well, nobody is starting up the next General Dynamics in a dorm room. I can just about guarantee you that.

FY 2017 sales are broken up across the following business segments: Information Systems & Technology, 29%; Aerospace, 26%; Marine Systems, 26%; and Combat Systems, 19%.

So I like to think of General Dynamics as 75% defense contractor (providing products such as the Virginia-class nuclear-powered submarine and the Abrams main battle tank, as well as supportive and complementary services and communications), and 25% corporate jet manufacturer (through the Gulfstream business jet).

This is a nice mix because you have two wonderful businesses that are diverse and distinct enough in and of themselves, which insulates the company from independent issues in either the public or private sector at any given time.

But it exposes them to increased military spending and corporate travel, both of which have been extraordinarily strong of late.

It also means that General Dynamics isn’t overly reliant on the US government for revenue, unlike some of their defense contractor peers. 61% of FY 2017 revenue came from the US government.

And it also means the dividend should remain secure and growing, through the ups and downs of the economy.

Indeed, the company has increased its dividend for 27 consecutive years.

That stretches right through multiple economic downturns, including the more recent Great Recession.

An impressive track record that’s made even more impressive by the growth rate: the 10-year dividend growth rate is sitting at 11.5%.

And that’s been very consistent, too. No marked deceleration in dividend growth.

With that consistent and reliable dividend growth, you’re also locking in a 1.82% yield right now.

The dividend looks set to continue flowing and growing, based on the very sustainable payout ratio of 37.6%.

This isn’t the highest-yielding stock around, but you’ve got decades of really strong dividend growth that looks set to continue for years into the future.

Of course, in order to reasonably estimate that future dividend growth, we need to look at the overall growth of the business.

So we’ll next take a look at what the company has done over the last decade (using that as a proxy for the long term) in terms of top-line and bottom-line growth.

We’ll then compare that to a near-term professional forecast for profit growth.

Blending the known past and estimated future in this manner should allow us to extrapolate out a reasonable trajectory of profit growth, which should then tell us a lot about future dividend growth and even the intrinsic value of the business.

General Dynamics has increased its revenue from $29.300 billion in FY 2008 to $30.973 billion in FY 2017. This is basically flat.

I’d prefer to see at least low-digit top-line growth, even from a fairly large and mature company like this.

However, revenue growth isn’t the only, or even the most important, part of the puzzle.

Indeed, there are many levers a great business can pull to squeeze out satisfactory profit and dividend growth from static revenue.

Share buybacks are one lever, and General Dynamics has amazingly reduced its outstanding share count by almost 24% over the last decade.

That has been a boon for earnings per share growth, with the company growing its EPS from $6.17 to $9.56 over this 10-year period. That’s a compound annual growth rate of 4.99%.

This isn’t exceptional, but this was a tough period. You had the Great Recession at the start, then there was the sequestration in 2013.

But we appear to finally be moving past sequestration, with President Donald Trump signing a ~$700 billion defense spending budget at the end of 2017 that exceeds prior caps.

Moving forward, CFRA is forecasting General Dynamics to compound its EPS at an annual rate of 6% over the next three years.

This wouldn’t be a huge acceleration off of what’s already transpired over the last decade, but it would allow for that long-term dividend growth rate to more or less continue for the foreseeable future due to a combination of solid EPS growth and the potential for a very slight annual expansion of the payout ratio.

Part of the forecast here is the very recent $9.6 billion acquisition of IT contractor CSRA, which has turned General Dynamics into the government’s tech services supplier.

This move is expected to be accretive to GAAP EPS by 2019.

In addition, there’s the continued share repurchases and potential for margin expansion on the aerospace side.

With a funded backlog of $55.4 billion (as of the most recent quarter), General Dynamics isn’t short on work or opportunities.

Moving over to the balance sheet, this has long been a source of strength for the business.

The balance sheet, as it sits at the end of FY 2017, is very strong.

The company has a long-term debt/equity ratio 0.35 and an interest coverage ratio of over 35.

The former number is even better than it looks, due to the large amount of treasury stock.

Furthermore, cash on hand equates out to almost 75% of long-term debt.

Now, the balance sheet will surely change by the end of this year, as the aforementioned acquisition of CSRA just closed earlier this year.

But the acquisition wasn’t so large as to dramatically change/impact the balance sheet, yet the accretive and synergistic nature of the transaction should work out very well over the long run.

The CSRA acquisition has slightly transformed General Dynamics, moving the company toward more of an IT/services and aerospace company. This bodes well as the future of warfare becomes more electronic in nature.

Profitability is fairly robust, and it’s improved in recent years with a slight margin expansion.

Over the last five years, the company has averaged annual net margin of 8.80% and annual return on equity of 23.39%.

ROE is particularly impressive when considering there’s been very little leverage employed; however, that’s offset a bit by the fact that treasury stock artificially lowers common equity.

This is, overall, a high-quality company that is almost surely facing a better future than the past decade.

Yet the last decade still brought about double-digit dividend growth, which is a very attractive floor for dividend growth investors to be looking at.

As the company transforms into more of a high-margin IT company with a scaled aerospace business that has a huge backlog, the dividend should remain sustainable and growing at an impressive rate for years to come.

Of course, any major drop in US defense spending will negatively affect General Dynamics.

But at an appealing valuation, this is a compelling dividend growth stock for long-term investment.

Well, the valuation does look fairly appealing right now…

The stock is trading hands for a P/E ratio of 20.63 right now, which compares favorably to the broader market.

That’s also well below the industry average P/E ratio.

And that’s on a great business that might just be becoming greater.

Meanwhile, the P/CF ratio of 19.5 is lower than the stock’s own three-year average ratio, all while the company believes the CSRA acquisition will be accretive to cash flow.

At first look, the valuation appears to be at least mildly appealing, especially in an elevated market. But what might a reasonable and balanced estimate of intrinsic look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and an 8% long-term dividend growth rate.

That DGR is on the upper end of what I normally allow for, but you could just as well argue that it’s pretty conservative since there’s nothing indicating that the low-double-digit dividend growth won’t continue for the foreseeable future.

The low payout ratio, accelerating EPS growth, huge backlog, margin expansion, and accretive CSRA acquisition all point to 10%+ dividend growth.

But I do like to err on the side of caution, and I’m also factoring in a slight deterioration to the balance sheet, which is why I’m sticking with a rather conservative DGR.

The DDM analysis gives me a fair value of $200.88.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

My analysis, albeit awfully conservative, shows a high-quality dividend growth stock that looks to be roughly fairly valued here.

One could do a lot worse in this market, but I’m also cognizant of my analysis and valuation being limited by my own perspective.

To broaden that perspective and add depth to the valuation, we’ll compare where I came out to where professional analysis firms are coming out at on this stock and its valuation.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates GD as a 3-star stock, with a fair value estimate of $220.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates GD as a 4-star “BUY”, with a 12-month target price of $248.00.

So we can see that I did, indeed, come out the lowest. Averaging the three numbers out gives us a final valuation of $222.96, which would indicate the stock is possibly 10% undervalued right now.

Bottom line: General Dynamics Corporation (GD) is a fantastic company with scaled and entrenched business lines that have very limited competition. With a rock-solid balance sheet, accelerating growth, almost three decades of dividend raises, a low payout ratio, double-digit dividend growth, and the potential that shares are 10% undervalued, this is a high-quality dividend growth stock that could offer up some defense for a diversified portfolio.

-Jason Fieber

Note from DTA: How safe is GD’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 95. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, GD’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

Perfect Stock Caught Trading Under Secret Name... [sponsor]
It trades under a secret name... for just $3. But thanks to a developing situation involving Donald Trump, America's No. 1 tech company and $10 billion... this may soon be the most talked-about stock in America. Find out more about the "secret stock" here.