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Morningstar | General Dynamics' 3Q Dissapoints, but We Think Shares Are Cheap Now. See Updated Analyst Note from 24 Oct 2018

Despite beating consensus expectations with EPS of $2.89, wide-moat General Dynamics' shares fell nearly 7% following third-quarter earnings. The beat was driven primarily by tax items and not from operational elements, and we note that operating margins contracted at each of General Dynamics' operating segments, save Mission Systems, which turned in a solid quarter. Revenue jumped 20% thanks to the CSRA acquisition, but growth at the Aerospace and Marine Systems businesses was weaker than we expected. Controlling for amortization related to CSRA, consolidated operating margins contracted 80 basis points year over year to 13.2% (12.5% as reported). Management moved its EPS guidance range up 10 cents to between $11.10 and $11.15 a share for 2018. But taxes drove much of the improved guidance.

In response to the poor quarter at Aerospace and Marine Systems, we have trimmed our 2018 and 2019 estimates for both segments. Although our near-term outlook has deteriorated, we left our midcycle operating margins largely unchanged at just under 13% including synergies from the CSRA acquisition. The net result was a $4 drop in our fair value estimate to $216 from $220. We continue to maintain that General Dynamics is one of the better run aerospace and defense firms we cover and that the company's structural competitive advantages should enable excess returns over the long term. To be sure, investors will have to stomach margin headwinds as the G500 and G600 ramp-up over the next 9 to 12 months, but we posit that shares are undervalued, trading at a price to our new fair value estimate of around 0.82 following the post-earnings sell-off.

We also think investors are focusing on the company's backlog and order intake performance. Although the company's total backlog expanded 5% sequentially, landing at $69.5 billion, nearly all this growth came from unfunded backlog in the Marine business and the Aerospace (business jets) backlog shrank 4% relative to last quarter. We continue to believe the business jet market is poised to rebound and view the decrease in backlog here as an artifact of supplier issues (Nordam bankruptcy) on the G500 and G600, which caused customers to hold off on ordering jets. Still, it's possible that recent equity market turbulence and trade war concerns could start weighing on customer sentiment more broadly.

Lastly, the Canadian prime minister has signaled that his government may freeze arm sales to Saudi Arabia due to human rights concerns; this move could impact General Dynamics, whose Canadian arm is delivering a massive military ground vehicle contract to the Middle Eastern kingdom. Canada serves as an intermediary customer for General Dynamics on this contract, and management maintained on the call that nothing has changed from its perspective, but we think there is a risk that the contract may be frozen. That said, we'd assume that Canada would be contractually liable to take delivery of vehicles already under contract.