Inevitable.
Not a word reserved only for Thanos.
It’s an important word to remember for investors.
Why?
Successful long-term investing means betting on the inevitable.
When you bet on the inevitable, and the inevitable plays out, profit inevitably flows.
It’s simple logic.
This is another reason why dividend growth investing is such a phenomenal investment strategy.
Many of the world’s best companies provide the products and/or services the world inevitably demands.
And they inevitably earn a lot of money doing so.
In turn, their shareholders also inevitably make a lot of money – often through rising cash dividends.
The Dividend Champions, Contenders, and Challengers list is evidence of this.
That’s a list of more than 800 US-listed companies that have raised dividends each year for at least the last five consecutive years.
Those reliable and rising cash dividends are the inevitable result of providing the aforementioned products and/or services.
And that growing dividend income can be the key to unlocking financial freedom.
I’ve used dividend growth investing to go from below broke to financially free and retired in just six years, as I lay out in the Early Retirement Blueprint.
Even with modest means, this strategy helped me build the FIRE Fund.
That’s my real-money early retirement dividend growth stock portfolio.
It generates the five-figure passive dividend income I live off of in my 30s.
But as powerful as dividend growth investing and betting on the inevitable can be, it’s imperative that an investor pay attention to valuation at the time of investment.
Price is what you pay, but value is what you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value. It’s protection against the possible downside.
Buying high-quality dividend growth stocks when they’re undervalued can be a surefire path to tremendous wealth and passive income over the long term.
Fortunately, valuing dividend growth stocks isn’t as difficult as you might think.
Fellow contributor Dave Van Knapp has made the valuation process even easier.
His Lesson 11: Valuation, part of a comprehensive series on dividend growth investing, puts forth a valuation template that you can apply to just about any dividend growth stock out there.
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.
FY 2018 sales are broken up across the following business segments: Information Technology, 23%; Aerospace, 23%; Marine Systems, 24%; Combat Systems, 17%; and Mission Systems, and Mission Systems, 13%.
Some of their major platforms include the Stryker combat vehicle, Abrams tank, the Virginia-class nuclear-powered submarine, Gulfstream business jet. In addition, they offer a suite of IT services.
Revenue for FY 2018 breaks down geographically as follows: 65%, US government, 21% international defense and commercial, and 14% US commercial.
If we want to talk about the inevitable, let’s talk about human conflict.
As the recent US airstrike that killed Iranian general Qassem Soleimani shows, human conflict is inevitable.
Conflict between human beings, now exemplified as conflict between nations, stretches back to the very beginning of our species. And I don’t see that ever changing.
Thus, companies that provide defense systems are, unfortunately, necessary.
General Dynamics could be thought of as roughly 3/4 defense contractor (including their IT offerings) and 1/4 corporate jet manufacturer.
It’s a business mix that is quite unique among defense contractors, and this mix is advantageous.
It offers a “best-of-both-worlds” situation.
That’s because you have that large exposure to the defensive nature of defense – the USA’s defense spending has been regularly growing for years.
Defense has recession protection built right in.
After all, a country doesn’t need less defense in times of economic struggle. If anything, it could need more.
Furthermore, the company’s recent $9.6 billion acquisition of CSRA turned it into the largest provider of IT services to the US government.
In a world where warfare is becoming increasingly digital, General Dynamics has positioned itself well.
Meanwhile, through the Gulfstream business, General Dynamics is less reliant on US defense spending than some of its peers.
The aerospace business gives General Dynamics diversification into unrelated commercial markets.
And it offers some stabilization if/when US budgetary crises or US DoD spending pressures occur.
However, seeing as how the US recently passed a massive $738 billion defense spending bill, I don’t see any US DoD spending slowdown on the horizon.
In fact, the contracts for General Dynamics keep coming.
The DoD awarded the company’s CSRA business a $7.6 billion cloud contract back in August 2019.
Then the company won a $22.2B contract from the U.S. Navy in December for construction of nine Virginia-class submarines.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Human conflict is inevitable. And it sure seems like a rising dividend from General Dynamics is also inevitable.
As it sits, they’ve increased their dividend for 28 consecutive years.
That’s by far the longest dividend growth track record among major US defense contractors.
The 10-year dividend growth rate is 10.4%.
Notably, the dividend growth shows no marked sign of deceleration. It’s incredibly dependable. The most recent dividend increase came in at just under 10%.
With a low payout ratio of 35.4%, the dividend is healthy and poised to continue growing as it has been.
Meantime, the stock offers an attractive yield of 2.26%.
This yield is definitely higher than what the broader market offers. It’s also more than 20 basis points higher than the stock’s own five-year average yield.
The dividend metrics check all the boxes. Growth, sustainability, and yield.
Of course, this is all backward-looking.
We ultimately invest in where a company is going, not where it’s been.
Revenue and Earnings Growth
I’ll now build out a forward-looking growth trajectory for General Dynamics, which will later help us value the stock.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional forecast for profit growth.
Combining the proven past with a future forecast like this should help us reasonably extrapolate out a growth course.
General Dynamics grew its revenue from $31.981 billion in FY 2009 to $36.193 billion in FY 2018.
That’s a compound annual growth rate of 1.38%.
Revenue growth has been modest.
I’d actually say that it’s been closer to flat.
That’s because revenue sharply ramped up in FY 2018, which was due to the aforementioned acquisition of IT-provider CSRA.
Without that acquisition, the growth rate would be even lower.
But thanks to margin expansion and aggressive share repurchases, the bottom-line growth has been more impressive.
Earnings per share increased from $6.17 to $11.18 over this stretch, which is a CAGR of 6.83%.
Buybacks have been especially meaningful. The outstanding share count is down by approximately 23% over the last 10 years.
Looking forward, CFRA is forecasting 6% compound annual EPS growth for General Dynamics over the next three years.
Not exactly a bold call. CFRA is basically saying they believe things will continue on as they have been.
Seeing as how General Dynamics is so consistent with everything they do, this seems like an appropriate prognostication.
CFRA cites US defense spending, a large funded backlog ($54.0 billion at the end of Q3 FY 2019), buybacks, and improved execution as tailwinds.
However, CFRA notes pressures on margins from increased supplier costs and a greater percentage of business from government IT. In addition, the balance sheet was stretched by the CSRA acquisition.
The US airstrike that killed Soleimani is a new development, but that may serve as an additional near-term tailwind for defense contractors like General Dynamics.
I think a 6% near-term EPS growth forecast for General Dynamics is sensible, if a bit conservative.
The company is arguably positioned better now than they have been at any point over the last decade, with CSRA on board, a huge backlog to work through, less shares outstanding, and significant spending from the US DoD.
But even if 6% EPS growth is what transpires, the dividend is nonetheless set to continue growing at a rate in line with the long-term average.
The payout ratio is low enough to ensure that ~10% dividend growth can continue for years to come, even with an EPS growth rate that lags that mark.
Financial Position
Moving over to the balance sheet, General Dynamics has long had a fortress balance sheet. But the CSRA acquisition has caused some deterioration here.
The long-term debt/equity ratio is 0.98, while the interest coverage ratio is at ~12.
A large amount of treasury stock has artificially lowered common equity, so the long-term debt/equity ratio looks higher than it really is.
But there’s still been a reduction in balance sheet quality relative to what General Dynamics has historically maintained.
That said, the company is by no means in financial dire straits.
The balance sheet is very solid. Just not amazing, like it used to be.
Profitability is one of the best elements of the business, with robust numbers across the board.
Over the last five years, the company has averaged annual net margin of 9.14% and annual return on equity of 25.52%.
Exceptional.
For perspective, Lockheed Martin Corporation (LMT), the largest US defense contractor, has struggled to average net margin above 8% over the last five years.
Overall, I see General Dynamics as a high-quality company that’s perfectly positioned to profit from the inevitable.
By extension, the growing dividend is practically inevitable.
Limited competition through an industry oligopoly, immense scale, technological know-how, and nearly insurmountable barriers to entry provide the company with durable competitive advantages.
That further cements the inevitability of profits and dividends.
But there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
While the company has a unique business mix and diversification, it’s still highly sensitive to any changes in the US DoD budget.
Moreover, they’re exposed to economic cycles with their commercial business. A major global recession would almost certainly lead to reduced demand for business jets.
And the balance sheet, while solid, has deteriorated in recent times.
Stock Price Valuation
If one can buy this stock when it’s undervalued, though, it could be an excellent long-term investment.
Well, I’d argue the stock looks undervalued right now…
This stock is trading hands for a P/E ratio of 15.64.
That’s definitely much lower than the broader market.
It’s also materially lower than the stock’s own five-year average P/E ratio of 17.6.
Even the P/CF ratio of 19.9 is off of its own three-year average P/CF ratio of 21.6.
And the stock’s current yield, as noted earlier, is more than 10% higher than its own recent historical average.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value 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, in my view, a very reasonable expectation for both the short term and long term.
This is lower than what General Dynamics has done for shareholders over the last decade. And they’ve been remarkably consistent with those ~10% annual dividend raises.
Furthermore, the payout ratio is very low.
However, the proven 10-year EPS growth rate, as well as the forward-looking CFRA EPS growth projection, would portend something a bit lower than those 10% dividend raises that shareholders have become accustomed to.
I’m splitting the difference between the 10% dividend growth and the 6% EPS growth projection.
Meeting in the middle, especially with that low payout ratio, seems fair to me.
The DDM analysis gives me a fair value of $220.32.
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.
This was not an aggressive valuation, yet the stock still looks greatly undervalued.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
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 $188.00.
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 3-star “HOLD”, with a 12-month target price of $190.00.
I came out high, which is surprising to me. Averaging the three numbers out gives us a final valuation of $199.44, which would indicate the stock is possibly 11% undervalued.
Bottom line: General Dynamics Corporation (GD) is a high-quality company with durable competitive advantages. Investing in this company is betting on the inevitable. With a market-beating yield, double-digit dividend growth, a very low payout ratio, almost 30 consecutive years of dividend raises, and the potential that shares are 11% undervalued, this is a stock that dividend growth investors should carefully consider right now.
–Jason Fieber
P.S. General Dynamics is just one of my Top 10 Stocks for 2020. All 10 stocks I’ve identified are high-quality dividend growth stocks with above average yields and attractive valuations. In fact, if I had $10,000 to invest in just 10 stocks, these are the first 10 stocks I’d consider right now. Click here to learn more.
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 97. 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.
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