Friday, May 10, 2013

A case for value in plain sight: General Dynamics

Company Background

General Dynamics manufactures submarines, armored vehicles, defense-oriented information technology systems, and Gulfstream business jets. The company operates under a decentralized structure with four reporting segments: (1) Aerospace (22% of 2012 sales), (2) Combat (26%), (3) Marine (21%), and (4) Information Systems and Technology, or IS&T (31%) The firm gets around 66% of revenue from the U.S. government.

Financial State

General Dynamics has a total debt of $9.6 billion ($5.7 billion in retirement liabilities and $3.9 billion of long-term debt) and $3.7 billion in cash. The company generates around $3 billion in operating cash flow annually and needs around $1.3 billion to fund its dividend and capital expenditure needs. The company has ample financial flexibility even after reducing its share count by 10% during the last five years. 

Key highlights as follows:
  • Revenues have grown from $19B in 2003 to $31.5B in 2012 - CAGR of ~ 6%
  • Free cashflow has grown from $1.5B in 2003 to $2.2B in 2012 - CAGR of 4%
  • Shares outstanding have reduced from 399M in 2003 to 353M now buying back at about 1.2% per year
  • Dividend has increased from $0.72/sh in 2003 to $2.52 / sh in 2012 - CAGR of 13%

Competitive Advantages

Financial strength suggests existence of  sustainable competitive advantage(s). Following are what I believe to be the key to GD's performance. 
  • Large marketshare and incumbent provider in an industry with high barriers to entry
  • Economies of Scale
  • Culture and history of good allocation of capital


Executive compensation is not excessive and has averaged 0.12% of revenue, 1.26% of EBITDA and 1.54% of FCF for the last 5 years. I find the CEO, Phebe Novakovic, to be refreshingly direct, honest and clear in what she wants to focus on. The following few quotes sum up how she thinks about the business, where she thinks its going, what they do best and she does not try to spin the bad news (emphasis added).

"...What you're going to see us do is pursue, and I can't say this enough, pursue margin expansion and generate cash and earnings. We are not going to chase revenue. We're going to stick to our knitting and do what we know how to do. This Company has a long history of operating excellence, and it's perform, perform, perform..."

"...With respect to the fourth quarter, I'd focus you on the revenue drop versus the same quarter a year ago, the single largest cause of which is the revenue decline at European Land Systems. This is the salient fourth quarter impact that carries over into 2013..."

"...The opportunities for upside and they are significant, are margin improvement, cash generation and driving performance via the equation. We will focus this year on operations, drive cost out of our businesses and improve performance and I do not intend to guide you to higher operating margins that are currently embedded in our plan because we have yet to earn them..."

"...let me give you a little bit on cash, and you've seen this in '12 and you're going to see it again in '13. Our cash generation in the underlying business continues to be superb. We have considerable CapEx in '12, and again in '13. In '13 we have planned at about $618 million, that's primarily at Gulfstream and I can tell you we're going to work that number very, very hard. We also have some headwinds in cash with respect to pension, and as I mentioned, higher CapEx. But let me talk to you a minute about a subject that's near and dear to my heart, and that's capital deployment. I think it should be clear from what I've told you is that I'm going to remain, and as is our management team, focused on operations in 2013. I can tell you there is almost no acquisition candidates in the current pipeline. I also believe that the acquisition process at GD is somewhat broken, and I will not venture back into that market until we have reestablished the discipline in this process. I can give you a little bit more color on this. If you consider the acquisitions that were made in Combat, Force Protection in particular, and the repair businesses in Marine, they were excellent. The recent IS&T acquisitions haven't been so far. Regarding dividend and share repurchases, I'm just not going to get ahead of my board..."

"...It ought to be clear from the charges that in some respects we took our eye off the ball. Some of our business units performed superbly, but that benefit hasn't accrued to the benefit, or that value hasn't accrued to the benefit of our shareholders, and you can better believe that we're going to be focused like a laser beam on that. I can tell you that I have – I'm very close to our business unit presidents, I know their business, they know their business, and we are completely aligned with the prime directive. That prime directive is, drive costs out of our business, generate earnings in cash, expand our margins, and reassure our shareholders that we're wise stewards of their capital. We are going to be focused on operations and you're going to see that across every single one of our business group. Let me tell you something else too as I think about our business. One of our key jobs is to manage and mitigate risk, and classical risk there (you argue) through diversification. And one of the things that I think we need to understand about GD is we have diversification in two respects. First and clearly, we have diversification in countercyclicality with Aerospace and defense businesses, right, it’s pretty axiomatic. Second, however, within our defense businesses we are somewhat countercyclical with the Navy and the Army, our exposure to the Army and the offsetting exposure to the Navy portfolio. So, while I see some contraction in our Army market, the Navy tends to be – as a result of tactical changes in the budget, the Navy tends to be more strategically driven and vary depending on whether we're in hot war; that balance between the Navy and the Army. So, when you look at that, even within the defense portfolio, I like our balance..."


Looking over a 10 year period, FCF has gone from $1.5B to $2.2B at a CAGR of 5% and an average FCF/ year of $2.2B. Meanwhile shares outstanding have gone from 398M to 353M - a buyback of about 1.2% / year. 

Considering this is a company with sustainable competitive advantage, assuming that FCF stays at the 10 year average and no additional share buyback FCF / share ~ $6.2, which at a 15 multiple, makes it equal to about $93 / share. 

On an EBITDA basis, 10 year average EBITDA = $3.1B which at 8x should make GD worth at least $24.8B in value. Add back $3.7B in cash, back out $3.9B of debt and you have an equity valuation of $24.6B or $24.6B / 353M ~ $70. So the market is valuing a company with a history of good capital allocation that has increased dividends at 15% per year over the last 10 years, with a management who is focused on generating cash and increase margins at 8x 10-year average EBITDA - a bargain in my view.

Key Risks

So why is the market offering such a good and consistent company at such a bargain valuation?
There are three reasons for this:

  1. Dependence on government for revenues (66% of revenues come from US Govt) means sequestration and any budget cuts could have a negative impact on revenues. 
  2. A large charge in Q4 that resulted in an earnings loss
  3. Pension Obligations underfunded to the tune of just over $4.9B - and that number may actually be understated and is closer to $5.5B.

I am making the case that the implied discount is a lot steep than it should be. Here is why:

  1. We are living in a world where there is constant threat of war, I dont see the defense spending coming down anytime soon but if it did, it will still take a little while to show up due to the backlog on the books.
  2. The quarterly charge was a one time accounting charge - the FCF for the year 2012 was still $2.2B.
  3. Reported status of a pension plan has a lot to do with assumptions - especially, the discount rate and expected long term return on assets. The company used 5.22% for discount rate and 8.24% for expected rate of return. I think both those are aggressive - certainly with the run up in the market the expected rate of return should probably be closer to 2.5% (expected 10 year return from market per total Market Cap / GDP metric) and discount rate closer to 3% (10 year high grade corporate bond). The foot notes show a sensitivity to 25bp of change to discount rate ($31M) and expected rate of return ($16M). If we make the adjustments, then the Pension obligations are actually understated by $650M. So the total pension obligation is underfunded by closer to $5.5B. To put into perspective as to why I dont think its that big a deal, the company could easily borrow that amount today and pay a 3% interest rate and its pension obligation would be funded even under my conservative scenario. Or it could simply use $700M of annual FCF  and cover its obligations in 7 years time with current assumptions. That would still leave $1.5B in cash for dividends and buybacks.


The key to the valuation and holding the stock is that GD continues to generate free cashflow at 2.2B/year or better and EBITDA of $3.1B or better.

When that changes for the worse, it will be time to reevaluate the analysis.

Saturday, July 7, 2012

Deliberate Practice: Dairy Queen 1997

In a first of what should be a long and educational series, Whopper Investments has a valuation exercise on Dairy Queen in 1997 right before Warren Buffett bought it. This post outlines how much I would have paid for it from an EV point of view.

DQ is a franchise business selling fast foods and dairy products. Financials suggest it is a steady business with pricing power. Based on the table below, I estimate paying for earnings before taxes of about $55M / year. 

Income before income taxes 56,745,147
EV multiple 12.5
EV = EBIT * Multiple $709,314,338
Debt $24,760,321
Cash and cash equivalents $38,384,589
Equity Value $646,169,428
Outstanding Shares 22,122,240
Price Per Share $29

I would not want to pay for more than 15 times earnings, so I expect that EV is not more than $850M and more than likely to be between $700M - $750M. So the buy out price should not exceed $35 and my preferred price would be between $29 - $30 per share.

Multiple EV Equity Value Price / Share
8 $453,961,176 $390,816,266 $17.67
9 $510,706,323 $447,561,413 $20.23
10 $567,451,470 $504,306,560 $22.80
11 $624,196,617 $561,051,707 $25.36
12 $680,941,764 $617,796,854 $27.93
12.5 $709,314,338 $646,169,428 $29.21
13 $737,686,911 $674,542,001 $30.49
15 $851,177,205 $788,032,295 $35.62

The Goal

This blog is really the result of  Whopper Investments post about merits of  writing a blog to improve investing skills and accelerate learning. I am a value investor focused on investing in companies with a sustainable competitive advantage at fair / low prices. I have learnt enough about myself to know that I am not that good at sticking with distressed investments/ net-net investments. I prefer to buy really good companies at fair prices and then have the patience to hold for long periods of time.

I have tended to identify companies in a formulaic manner. While my performance so far has been average, I feel the strong need need to move to a more concentrated portfolio with higher amount invested per position and fewer positions. I'd like to have conviction to put at least 20% of my portfolio into a single idea. My present approach involves identifying businesses with long term competitive advantage through financials. It does not identify the specific advantage and whether the next 10 years will look like the past 10 year. Without this knowledge I am forced to diversify. As I look back at my past investments, a few ideas have generated substantially higher returns - not an uncommon occurrence. If I can get closer to understanding the business better, I can increase amount invested per position and improve returns in the process. The outcome should be higher returns with lower risk - Risk being defined as not know what I am doing.