Morningstar | Disappointing 2019 Guidance Sends GD Down; We're Trimming FVE, but Shares Still Undervalued
Wide-moat General Dynamics delivered an EPS beat for the last quarter 2018, but cash flow came in lighter than we expected because of missed payments on the $12 billion Saudi Arabia ground vehicle contract. The 2019 outlook disappointed, coming in below both our expectations and consensus estimates. We're trimming our 2019 projections for revenue and earnings, and we also brought down our midcycle estimates slightly, which resulted in a $7 cut to our fair value estimate, which now stands at $209.The firm ended 2018 with a surge in revenue (year-over-year growth of 25%) due to nine G500 deliveries in the fourth quarter and the inclusion of CSRA. Operating margins, however, contracted by 100 basis points, falling to 11.8% in the quarter. Much of the blame can be placed on aerospace, where margins dropped 310 basis points due to mix, the G500 ramp, and challenges at Jet Aviation. Backlog was up 7.5% compared with 2017, but the inclusion of CSRA boosted year-end 2018 considerably. More telling is the sequential fall in backlog, down 2.4% versus the previous quarter and still down even when including the $1 billion business jet order that slipped into 2019, as the deal awaits approval from the corporate customer's board.
The 2019 guide came in below our expectations at $38.5 billion of revenue ($39.7 billion Morningstar) and $4.5 billion of operating profit ($4.75 billion Morningstar). The company’s midpoint for 2019 EPS stands at $11.65. GD IT appears to be driving the downbeat revenue forecast, noting that divestments will weigh on revenue. Still, we think increasing Defense Department outlays should be driving revenue growth, particularly in GD IT's shorter-cycle services business. In contrast, aerospace's 2019 outlook for revenue came in strong at $9.7 billion. Guidance implies about 11.7% consolidated operating margins, which is a bit below our initial 12% forecast due to weak profitability out of aerospace and GD IT margins a little lower than we anticipated.
We'll be watching the $12 billion Saudi Arabia LAV contract closely given the potential for the Canadian government (Canada holds the contract even though Saudi Arabia is the ultimate customer) to cancel the contract in the wake of human rights controversies. Should Canada cancel the contract it would be required to pay about $750 million (about CAD 1 billion). But the fine isn't the real issue. Prime Minister Justin Trudeau faces federal elections in October of this year and the General Dynamics facility producing the ground vehicles for Saudi Arabia employs thousands in London, Ontario. Cancelling the Saudi contract would put some of these jobs at risk and such a move would also materially affect our growth and profit forecasts for the company's combat systems unit and we note that program cancellation isn't reflected in our base-case valuation of the company. Even if there isn't an outright cancellation, we think Saudi Arabia getting current on its payments (General Dynamics management believes it will) is a key item for cash flow performance in 2019.
General Dynamics is an aerospace and defense company. The company has five operating segments: Aerospace, which provides a family of Gulfstream aircraft and services for business aircraft produced by Gulfstream and other original equipment manufacturers; Combat Systems, which provides combat vehicles, weapons systems and munitions; Information Technology, which provides information technology (IT) services, IT infrastructure modernization and professional services; Mission Systems, which provides mission-critical products and systems; and Marine Systems, which designs and builds nuclear-powered submarines, surface combatants, and auxiliary and combat-logistics ships.
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