General Dynamics Corp.’s share price has remained stable during the past 12 months despite the threat of government budget cuts.
Ashley Lapin/MEDILL
(ARTICLE ORIGINALLY PUBLISHED MARCH 20, 2013 ON MEDILL REPORTS CHICAGO)
The war was over. After decades of fear, proxy wars and preparation for a nuclear attack, the U.S. government no longer needed to commission as many military implements.
When the Cold War ended, this was the reality defense contractor General Dynamics Corp. faced. As Uncle Sam dialed back defense outlays in the era of what was known as the “peace dividend,” the company was able to still run a profitable business by serving both government and private-sector clients.
Now, a little over two decades later, it’s possible that the same situation could repeat itself: as of March 1, because of what’s known as the “sequester,” the U.S. government is significantly cutting its spending on defense contracts.
That is bad news for GD, which is currently one of the nation’s top five defense companies. The Falls Church, Va.-based company’s vast line of defense products include submarines, surface warships, combat tanks, and Stryker combat vehicles, along with a host of intelligence, surveillance and reconnaissance systems, and cyber security systems.
General Dynamics Corp.’s 2012 revenues broken down by sector.
Ashley Lapin/MEDILL
Of course, the government has already been reducing its defense outlays, as it winds down the wars in Afghanistan and Iraq. Now, with the sequester’s looming cuts in defense, GD may be vulnerable to a drop in business.
When the company reported its 2012 results early this year, CEO Phebe Novakovic acknowledged the difficulties GD faces with the government cuts in defense spending, but stayed upbeat. “We will continue to manage our business aggressively as we approach the opportunities and the challenges of the future,” Novakovic said.
General Dynamics, which traces its roots back to 1899 when it was called the Electric Boat Co., has over time branched out to encompass aerospace, combat systems, information systems and technology, and marine systems.
After the end of the Cold War, the company shed much of its military defense businesses, but in the late 1990s began once again to expand its presence in that sector. As a result, GD was well positioned to profit from the upswing in U.S. defense needs, particularly during the first decade of the 21st century.
The recent difficulties mentioned by Novakovic were reflected in GD’s 2012 results, which showed a 3.6 percent decline in revenues, to $31.51 billion. The softer revenue had been expected, because of diminishing government spending. Thanks to a $2 billion “impairment” charge linked to mark down the value of GD’s Information Systems & Technology group and certain other charges, GD had a full-year net loss of $332 million, or 94 cents a share. Excluding the impact of those charges, adjusted earnings for the year were $6.48 a share.
Out of GD’s 2012 revenues, fully two-thirds came from the U.S. government. GD’s biggest revenue generator is its information systems and technology sector, which drew 43 percent of sales from the Defense Department, and another 42 percent from other federal agencies, according to a report by Morningstar analyst Neal Dihora.
With the nation’s budget deficit mounting, lawmakers passed the Budget Control Act of 2011, which mandated cutbacks in a variety of programs. The act will directly affect the defense sector with approximately $582 billion in cuts over a period of 10 years. The sequester, as it is called, will begin with a $55 billion reduction in defense spending in 2013 if no legislation is passed to change it.
While defense has long been GD’s bread and butter, it has been preparing for the effects of the sequester since 2011, when the Budget Control Act was signed into law and created the risk of a sequester, according to Rob Doolittle, staff vice president of communications for GD.
Still, if General Dynamics is going to be hit hard by the government’s defense cuts, the company’s share price offers little evidence that anyone is greatly concerned about the sequester’s potential financial impact on GD in 2013.
Lawmakers have until March 27 to pull things back from the brink; however, it is still uncertain whether or not they will come to an agreement.
One reason GD shares have held up as well as they have is likely due to the company’s plans for offsetting the loss in government spending with other sources of income. Among other things, the company’s aerospace group, which makes the highly popular Gulfstream line of private jets and isn’t exposed to the public sector, is growing rapidly.
Novakovic recently told analysts that GD will have to be “nimble” in the current environment, and added that opportunity is “clear at Gulfstream and in parts of our other businesses where we’re going to have organic growth.”
GD is also riding out the current turbulence because, like other defense contractors, it has already locked in contracts for the coming years. These include multiyear procurement orders which ensure that the company will receive the same amount of funding on an annual basis over a set time period (from two to five years).
Analysts surveyed by Yahoo Finance expect GD’s per-share earnings this year 2013 to $6.76 from the adjusted $6.48 last year.
Things could be worse. “A diversified offering with key platforms that ensure the superiority of the armed forces puts the company in an enviable position in a time of budget strains around the world,” says Morningstar’s Dihora.
“Though we think defense spending will ease in the coming years, an entrenched product range, a robust aerospace business and an operational focus will power the firm’s return on invested capital well above its cost of capital for years to come.”
According to Brian Ruttenbur, managing director for CRT Capital Group LLC, the fact that GD will be growing its business jet line is a solid positive for the company. However, Ruttenbur retains some concerns about GD’s outlook.
In an industry note on the defense/security & safety/space satellite technology, Ruttenbur said, “The company’s large exposure to the Army is a big negative in our view. We believe that the Army will be cut the most amongst the service branches in Sequestration. We estimate GD has approximately 34 percent of overall revenue tied to U.S. government services, which, by our calculation, is the second highest of the defense primes.”
In addition, he said, GD’s margins are beginning to erode,” and “we expect things could get worse in the coming years.”
Despite the defense budget cuts, it looks as if GD will ride out 2013 pretty well. Novakovic’s stance is clear.
“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,” she told analysts. “We are not going to chase revenue. We’re going to stick to our knitting and do what we know how to do.”
