General Dynamics: Strength In Defense

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General Dynamics (GD) carries our highest investment recommendation of 5-STARS, or "Strong Buy." The firm is a diversified defense and commercial aerospace firm, with its most important products being integrated technology systems for the Department of Defense and military branches (around 30% of revenue), Gulfstream private jets (25%), nuclear submarines and destroyers for the U.S. Navy (25%), as well as armored tanks and vehicles for the U.S. Army (20%).

General Dynamics' 2020 revenue and EPS were down 4% and 8%, respectively, primarily due to a sharp drop in demand for Gulfstream jets (due to the pandemic), while Defense revenues grew 3% for the year.

With private jet demand quickly recovering as the global economy reopens, and the Defense backlog up 8% in 2020, we expect GD to generate EPS growth of about 10% annually through 2023. Given this healthy outlook, we think shares are highly undervalued at just 12x 2022 EPS consensus vs. 19x for the S&P 500. The primary factor weighing on GD's current equity valuation is sentiment rather than weak fundamentals, in our view.

The conventional wisdom seems to be that demand for private jets will never fully recover, as the pandemic will lead to permanent reduction in business travel, and that flat or lower Defense budgets under the new Democrat administration will weigh on the firm's defense earnings.

We expect both of these sentiments will morph to optimism as 2021 progresses, leading to attractive multiple expansion for General Dynamics. The idea that business travel will be permanently reduced by virtual meetings, even after the pandemic, is a popular talking point right now, but we see evidence suggesting it is wrong.

From January to April 2020, U.S.-based business jet flights dropped 72%. But by last October, before the major resurgence of COVID-19 cases in developed economies, domestic flights for U.S.-based business jets had recovered to 1% above the January 2020 level. With COVID-19 vaccines now rolling out across the world, we expect business travel to strongly rebound in the second half of 2021 and throughout 2022, driving a full recovery and strong future growth for the company's Gulfstream business.

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