Morningstar | General Dynamics' Defense Businesses Growing as Business Jets Enter Transition; Shares Undervalued
General Dynamics closed its acquisition of CSRA, the largest in its history, and the smaller Hawker Pacific deal during the second quarter and unveiled a new reporting structure, which includes two new segments: information technology and mission systems. Results featured solid growth out of the defense businesses but falling revenue in aerospace systems. Management updated its full-year guidance to revenue of approximately $36.75 billion and $11-$11.05 in earnings per share. We continue to view shares of this wide-moat, exemplary-stewardship name as undervalued and plan to increase our fair value estimate by around $3 due to the time value of money.Revenue in the quarter moved up 19.7% year over year to $9.2 billion, but stripping out CSRA shows growth closer to 3%. All defense businesses grew at a healthy clip, registering 7.1% organic growth in the quarter, but aerospace systems revenue fell 8.8% on the back of lower large-cabin deliveries. Surprisingly, General Dynamics managed to squeeze 20%-plus operating margins out of aerospace systems, more than double those of business jet competitors. We anticipate margin compression toward the end of this year due to initial G500 deliveries. Consolidated margins fell to 11.8% versus 13.9% last year, but we attribute about 50Â basis points of that to CSRA costs; intangible amortization linked to the deal also weighed on margins. Nonetheless, excluding the new information technology segment still shows consolidated operating margins dropping around 30 basis points to 14.5%.
Despite a $0.20 headwind from CSRA acquisition costs, EPS increased $0.17 to $2.62 this quarter, thanks primarily to a lower effective tax rate. Although last quarter's cash flow came in light, we weren’t concerned and thought the company could recover. Management didn’t disappoint with free cash flow (operating cash flow less capital expenditures) of $612 million, the best second-quarter performance since 2014.
Management moved up revenue guidance slightly across all its businesses, resulting in a new 2018 revenue outlook of $36.7 billion-$36.8 billion, including CSRA. Consolidated operating margins are pegged at just above 12%. Both explicit CSRA acquisition costs, which management thinks will come in at $80 million during 2018, and intangible amortization of around $190 million, according to management, are weighing on operating margins. Management confirmed its objective for 100% free cash flow conversion (free cash flow as a percentage of net income) but expects to be slightly below this target in 2018.
Although we're not forecasting a significant increase in business jet deliveries this year over the 641 aircraft shipped last year, we maintain our view that the business jet market is going to rebound in 2019. Company orders this quarter confirm our view, and it reported a business jet book/bill of 1.3 on a dollar basis. Gulfstream had been running at a 1.0 book/bill over the last 12 months, and we think this metric will land at or above 1.0 in 2018, which would be only the third time this has occurred since 2009. Management mentioned strong demand for the G650 model, which was encouraging, given Bombardier’s introduction of the new Global 7500 later this year.
We got a better look at the new business segment, mission systems, which was split out from the old information systems and technology business following the closure of CSRA. Mission systems operates three business lines: intelligence surveillance and reconnaissance; communications; and platforms and sensors. The ISR business line drove the 9% year-over-year growth that mission systems achieved this quarter, and operating margins came in at 13.3%. Over the mid- to long term, we believe this business can achieve 13%-14% margins and should be able to grow at rates slightly above the overall defense budget thanks to its focus on C4ISR (command, control, communications, computers, intelligence, surveillance, and reconnaissance).
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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