General Dynamics Presides Over a Very High-Quality Portfolio of Businesses

Equity Analyst

Nicolas Owens

Revenue segments as reported by the company.

Aerospace

Marine Systems

Combat Systems

Technologies

Information Technology

Mission Systems

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Regulated margins, mature markets, customer-paid research and development, and long-term revenue visibility allow the defense contractors to deliver a lot of cash to shareholders, which we view positively because we don’t see substantial growth in this industry. Indeed, defense budgets usually ebb and flow with a nation's wealth and its perception of danger. In the U.S., both have been on the rise, and among many allies, notably Germany and Japan, geopolitics is leading to larger military budgets than we've seen for decades. For perspective, we estimate that the portions of the U.S. defense budget relevant to contractors like General Dynamics and its competitors and subcontractors shrank between 2011 and 2016 by 3.7% annualized while these budgets grew between 2016 and 2021 by 6.5% annualized. We think the contracting budget will continue to grow with modernization, but more moderately, averaging around 2.5%-3.0% over the next five years.

General Dynamics' defense portfolio is mostly dialed in for low single digit growth for the foreseeable future, with some business lines, including submarines, slated to offer slightly faster growth. In all these businesses, the goal for General Dynamics is to execute on delivering and working out more efficient processes to gain incremental profitability, which the company has a strong track record of achieving.

General Dynamics’ Gulfstream segment primarily produces long-range wide-cabin business jets. This market is low volume, with fewer than 200 global deliveries each year and many repeat customers. New, quality product drives demand in this segment, so the company must continuously convince customers that it has built a better aircraft. Gulfstream dominates volume in this segment, with roughly 50% market share, which leads to superior margins as it progresses along the learning curve. We anticipate the introduction of the G700, G800, and G400 in 2022, 2023, and 2025, respectively will be major sales drivers.

Business Strategy & Outlook

The durability of economic profits in the defense sector may seem paradoxical: defense contractors invest the billions to generate products on the cutting edge of technology, and unit pricing for their products declines over time. What's more, these companies primarily sell to a single buyer (referred to as a monopsony in economic texts, in this case the defense and procurement arms of the U.S. government)—one with rapidly evolving needs, a tendency to change product requirements, and intermittent squabbles over the bill. Despite these challenges, we observe that wide moats are prevalent in the defense business. They exist because of significant intangible assets: first among these is the extreme product complexity that thwarts new entrants, bolstered by decades-long product cycles, contract structures that reduce risk for the contractor and lock out alternative suppliers, as well as the switching costs of a risk-averse customer facing significant time and risk to potentially switch products. 

We believe that intangible assets in the defense industry ensure that incumbent firms are the only companies capable of servicing the military’s large need to purchase arms (broadly defined), which manifests as a material barrier to entry. In terms of keeping competition at bay, we believe the primary source of intangible assets is product complexity. First, the technology used in arms production requires extensive and specialized expertise that also usually lacks commercial viability outside of the defense industry (aside from commercial aerospace manufacturing), so a new entrant would likely need to develop this know-how entirely from the ground up and we observe only a few capable incumbents in each major category of defense systems development. Second, the development of a military program is long and expensive; a would-be competitor would face material sunk costs ranging from the challenge of developing a workforce that has the required experience and/or security clearances to enter the space to the time and money spent developing a prototype to pitch for a contract. We note that the only serious outside threat to a small subsegment of this business, space launches, are the pet projects of multibillionaires. We use the Stockholm International Peace Research Institute’s data set on the arms industry as evidence that the arms production industry is insulated from outside competition: Lockheed Martin, along with Boeing’s defense unit, BAE Systems, RTX, Northrop Grumman, Airbus, and General Dynamics have remained the top six or seven global arms producers for the past 15 years (a Chinese state-owned enterprise is the seventh in some of those years).

The second major intangible asset in the defense industry is the contract structure that allows excess return generation. Generally, defense prime contractors compete fiercely within initial bidding rounds to win contracts to design and develop a prototype for a new program. The government then usually selects one or more of the winning prototype bidders to deliver a small number of testable products, after which the winning prime contractor is awarded a low rate initial production contract, followed by full rate production and eventually sustainment business. After the original round of purchasing is completed, it is quite rare to see a government switch contractors. During the early stages of development and production, the government generally purchases using cost-plus contracts, which shift the financial burden of cost overruns to the customer, but the potential profit is lower. Given the immense risk of cost overruns in designing complex products such as bomber aircraft, this dynamic frequently works in the contractor’s favor. As programs age to the production phase, they tend to move toward fixed-price contracts, often split into phases or lots, where the unit economics evolve over time as production can be scaled up for a successful program. Although fixed-price contracts carry more financial risk because the burden of cost overruns rests on the contractor, they tend to be more profitable because manufacturing costs become better understood and can even decline significantly as a program ages and delivery volumes increase. Considering the opportunity for additional revenue and profits from maintenance of delivered weapons systems ("sustainment" in the military contracting jargon), these mature program contracts often become long-standing cash cows because program life cycles can last decades.

Switching costs for the military customer are generally predicated on the mission-criticality of the product, extended product cycles, a lack of viable alternative products, and the substantial time investment or risk involved in switching suppliers. The major products for U.S.-based defense contractors include military vehicles (including land, air, and sea-based vehicles), intelligence-gathering and communication systems, radars and sensors, and munitions. The ability for a military to succeed at its strategic objectives and defeat an adversary, as well as protecting the lives of soldiers and civilians, are contingent on these products working as intended, which we think protects the proven suppliers from upstart competition. Product cycles are a source of differentiation. We view the products with the longest procurement cycles, such as fighter jets and submarines, as the moatiest because contracts with decades-long fulfillments provide extraordinarily long-term revenue and profit visibility. We see short-cycle products, such as defense IT contracting less favorably. As contracts for defense hardware essentially grant a monopoly over that product, we also see some modest switching costs stemming from a lack of viable alternatives, but this is partially mitigated by the government’s right to license patents to third parties as well as the fact that product cycles for similar systems often overlap and may be provided by competing suppliers. More important to us is the extensive investment required to replicate a product that fulfills a mission. Product development in this industry ranges from years to decades, and if the military is dissatisfied with the product, it is much faster and easier to work with the existing contractor to fix it than to fund the development of a brand-new program to replace it. 

Following this framework, we view the moatiest segments as those with the most difficult-to-replicate products with the longest upgrade cycles and the longest production cycles. 

We believe the marine segment enjoys one of the widest moats in the defense industry. The company is one of only two major shipbuilders in the U.S. Though shipbuilding is not a growth market, the segment benefits from steady, decades-long procurement cycles and uses technology that is unique even among defense contractors (specifically outfitting the nuclear reactor chamber of submarines). This segment receives about two thirds of revenue from the Virginia-class attack submarine, a nuclear-powered boat and is a contractor on the Navy’s highest priority development program, the Columbia-class ballistic missile submarine, which is also powered through a nuclear reactor. Precisely two firms possess the technological capabilities to produce these products (in the United States) over any time horizon, and to preserve the know-how at both facilities, the Navy tends to split the work on its subs between General Dynamics and Huntington Ingalls. As the Navy plans to procure Columbia-class boats through 2042, we remain confident in the cash flow-generating capacity of the segment without needing to consider future contract wins. 

We think the combat systems segment is wide-moat. This segment generally produces land-based vehicles such as tanks and the Stryker family of wheeled combat vehicles, as well as similar systems for allied militaries globally. Product complexity for land-based combat vehicles prohibits new entrants, even among defense contractors. Land combat systems are incredibly long cycle, for example, the military has procured General Dynamics’ M1 Abrams tank consistently since the 1980s, including various technology and armor upgrades, as the Army’s main battle tank, which gives us confidence in General Dynamics profitable revenue-generating potential for years into the future (the U.S. Army's next generation tank is not due to enter service until 2035). This segment also benefits from switching costs stemming from the mission criticality of the product, as lives would be endangered if the product does not work as intended. 

We think the IT Services business unit within the technologies segment is less moaty than the rest of the General Dynamics portfolio, and we regard it as narrow moat. The core defense-contracting moat qualities apply to the IT services business, which provides data processing, cybersecurity, and intelligence services to the military, but are not as durable. While we agree that specialized individuals (for example, with technical and engineering know-how, often combined with security clearance) are required to service these contracts, and we see intangible assets associated with the organization's ability and learnings in implementing and integrating complex networked systems for government agencies, and with a focus on modernizing its infrastructure, that the U. S. military (and adjacent organizations) will demand such services in the near to medium term, we believe the rapid evolution of the technologies and the shorter contracting cycles do not beget a wide moat. As evidence of this, there are several more pure-play defense IT contractors than defense prime contractors, including Leidos, Booz Allen Hamilton, CACI, Science Applications International, as well as segments of other prime contractors such as RTX and Northrop Grumman (though these have in recent years divested much of their IT services and related business lines). Further, government IT contracts are recompeted periodically, which is not conducive to the generation of excess returns, as even if the contractor wins the re-bid contract it is likely to drive returns down closer to the cost of capital. This segment, which last reported standalone operating margin for 2019 earned lower margins than any other in the portfolio. General Dynamics cites the fact that IT Services and Mission Systems serve the same customer base and increasingly 'go to market together' which leads us to believe General Dynamics invested in this segment to maintain access to more opportunities to install and maintain more of its products.

We believe that General Dynamics’ mission systems business unit within the technologies segment is wide-moat. This segment produces various sensors, secure communication systems, and military electronics. The ability for soldiers to effectively communicate and navigate is a force-multiplier for the military. Since adversaries actively work to disrupt the ability of sensors to function as intended, we expect that the customer is highly sensitive to changes in the quality of the sensor or jammer. While product complexity does prevent new entrants into the industry, we do not believe the product complexity is insurmountable in this segment. We believe the primary moat source for this segment is switching costs stemming from a large installed base on long-cycle products such as satellites, ships, and aircraft as well as a highly mission-critical product. For example, General Dynamics produces the radomes or the encrypted communication systems on almost every U.S. military aircraft. Reoutfitting every military aircraft and retraining pilots on an alternate system would take years and would not accomplish much given the company’s stellar track record. We believe that reoutfitting the disparate communications hardware on various military products in various locations on earth or in space, along with commonality issues with other military products would make it incredibly difficult for the customer to change to a new provider, and the cost at failure for improperly implementing the change would be incredibly high risk for the military. 

General Dynamics’ aerospace segment, which is dominated by Gulfstream Business Jets, requires a different framework because it is a civilian product, but it still possesses a wide moat based primarily on the intangible asset of the complexity of aircraft manufacturing. The business jet market is a little more fragmented than the duopoly commercial aircraft market, but product complexity ensures that only Gulfstream, Bombardier, and Dassault can compete in the long-range, large-cabin end of the business jet market. This market comprises only about 700 deliveries annually (roughly 200 of which are long-range, large-cabin) and demand is generally driven by new, high-quality products, as previous customers must be convinced to upgrade. General Dynamics' aerospace division has outpaced competitors in terms of revenue and margins, taking substantial volume share since the introduction of the G650 in 2012, and has successfully managed the risk of making the transition to new aircraft, as it moved from the G450 and G550 to the G500 in 2018 and G600 in 2019 and plans to launch the G700 in 2023. Though Dassault and Bombardier have produced newer large-cabin products, we have not seen much evidence that these offerings have resonated as well with customers. Gulfstream has gained unit share within the large cabin segment and now has about half of total deliveries. The company consistently generates superior margins to competitors, likely due to progressing further along the learning curve. Gulfstream has an extensive, global product support network that allows them to regularly take the top position among product support networks, which creates a sticky stream of aftermarket revenue, representing about a quarter of segment sales. We believe that substantial service network benefits bolster the company’s moat by boosting the product line’s image as a luxury brand. We see some switching costs in the time it takes to retrain a pilot on the new aircraft, but believe intangible assets is the primary moat source for this segment.

Wide

Economic Moat

General Dynamics

General Dynamics Corp. is a global aerospace and defense company, which engages in design, engineering, and manufacturing to deliver state-of-the-art solutions. It offers a broad portfolio of products and services in business aviation, ship construction and repair, land combat vehicles, weapons systems and munitions, and technology products and services. It operates through the following segments: Aerospace, Marine Systems, Combat Systems, and Technologies. The Aerospace segment designs, manufactures, and sells business jets, and offers aircraft maintenance and repair, management, charter, aircraft-on-ground support and completion, staffing, and fixed-base operator services. The Marine Systems segment designs and builds nuclear-powered submarines, surface combatants, and auxiliary ships for the United States Navy and Jones Act ships for commercial customers, as well as builds crude oil and product tankers, and container and cargo ships. The Combat Systems segment manufactures land combat solutions, such as wheeled and tracked combat vehicles, Stryker wheeled combat vehicles, piranha vehicles, weapons systems, munitions, mobile bridge systems with payloads, tactical vehicles, main battle tanks, armored vehicles, and armaments. The Technologies segment provides information technology solutions and mission support services, mobile communication, computers, and command-and-control mission systems, and intelligence, surveillance, and reconnaissance solutions to military, intelligence, and federal civilian customers. The company was founded on February 21, 1952, and is headquartered in Reston, VA.

Earnings data Q3 2023

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General Dynamics Corp. is a global aerospace and defense company, which engages in design, engineering, and manufacturing to deliver state-of-the-art solutions. It operates through the following business segments: Aerospace, Marine Systems, Combat Systems, and Technologies. The Aerospace segment designs, manufactures, and sells business jets. The Marine Systems segment designs and builds nuclear-powered submarines. The Combat Systems segment manufactures land combat solutions. The Technologies segment provides information technology solutions and mission support services. The company was founded on February 21, 1952 and is headquartered in Reston, VA.

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GROTON, Conn. , Sept. 19, 2023 /PRNewswire/ -- General Dynamics Electric Boat, a business unit of General Dynamics (NYSE: GD), announced today it was awarded a $517.2 million delivery order against a previously issued basic ordering agreement for procurement and delivery of initial Virginia-class attack submarine spare parts to support maintenance availabilities.

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FALLS CHURCH, Va. , Sept. 18, 2023 /PRNewswire/ -- General Dynamics Information Technology (GDIT), a business unit of General Dynamics (NYSE:GD), announced today that it swept all initial task orders on the $4.5 billion Department of the Air Force Security Support Services indefinite-delivery/indefinite quantity contract.

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General Dynamics offers steady income through dividends. They have raised dividend distributions for over 25 years straight. The stock has an attractive valuation, with a price-to-earnings ratio below the sector average and a strong pipeline of contracts to reinforce future cash flows. General Dynamics obtains 70% of their revenue from government secured contracts.

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General Dynamics' market-beating dividend is set to remain easily covered in 2023. The company reported robust revenue growth in the second quarter. The aerospace and defense giant maintains a vigorous financial position.

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General Dynamics is trading below its 52-week high and is an attractive play for potentially strong total returns. GD has a steady and growing revenue stream from long-term government contracts, making it less vulnerable to economic downturns. Strong demand for military hardware and a record-high backlog support GD's near-term growth prospects.

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RESTON, Va. , Aug. 1, 2023 /PRNewswire/ -- The board of directors of General Dynamics (NYSE: GD) today declared a regular quarterly dividend of $1.32 per share on the company's common stock, payable November 10, 2023, to shareholders of record on October 6, 2023.

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