This contract win could actually be a loser for General Dynamics shareholders.
When you think of General Dynamics (GD -0.12%), what’s the first thing that comes to mind?
Tanks, probably. Seventy-ton armored behemoths roaming across the plains.
Image source: Getty Images.
In fact, though, while tanks are the product that General Dynamics is best known for, production of such “combat systems” is General Dynamics’ smallest business, accounting for only $8.3 billion of the more than $42 billion in sales GD makes in a year. Larger by far is General Dynamics’ “marine systems” business, which brought in $12.5 billion in revenue last year — a nearly 50% bigger business than combat systems.
Even more surprising, though, for a company best known as a defense contractor, is that not all of General Dynamics’ marine systems products are warships. While the company does specialize in the construction of nuclear-powered submarines and conventionally powered destroyers, General Dynamics also builds quite a few vessels that are more focused on keeping the U.S. Navy fueled and supplied than with actually conducting combat operations.
Image source: U.S. Navy.
$6.8 billion for fuel tankers
Case in point: General Dynamics’ latest naval contract, a $6.8 billion award to build oil tankers for the Navy.
On Sept. 13, the Pentagon awarded General Dynamics a sole-source, “block buy” contract to build eight John Lewis-class fleet replenishment oilers, hull numbers T-AO 214 through 221, between now and January 2035. General Dynamics’ San Diego-based National Steel and Shipbuilding Co. (NASSCO) subsidiary will do the work and, once constructed, the vessels will enter service with the Military Sealift Command, where they will be crewed by civilian mariners.
This is a sizable contract, of course, amounting to more than half a year’s average revenues for the marine systems division. Receipt of this single contract win isn’t, however, necessarily a great reason for investors to flock to GD stock.
Caveats and provisos
Why not? Well first and foremost, consider the timeline. $6.8 billion may sound like a lot of money, but spread over 10 years through the contract’s completion, it’s actually more like $675 million per year. That’s still a nice 5% boost to average revenues for the division — but closer to a 1.6% boost for the company’s annual revenues as a whole.
In other words, probably not enough to move the needle much.
A second reason to be less than excited about this news is the fact that, while General Dynamics’ second-biggest division by revenue, marine systems is the company’s least profitable division in terms of profit margins. Last year, for example, operating profit margins at marine systems ran to just 7% according to data from S&P Global Market Intelligence, versus the 10% margins that GD earns as a whole.
Simply put, if maximizing profits is your goal, adding revenues to General Dynamics’ marine systems division is literally the worst way to do that.
What it means for investors
Perhaps this is the reason why General Dynamics stock isn’t really up as much as you might expect on news of its winning a “$6.8 billion contract.” In the 10 days since the oiler contract was announced, in fact, GD stock has gained only about 2.6% — not much better than the 2% gain in the S&P 500 index.
In doesn’t help, of course, that General Dynamics remains a pricey stock. Valued at 24 times trailing earnings, the stock may look like a bargain in a market where the average S&P stock costs closer to 30 times earnings. However, General Dynamics’ 1.9 times price-to-sales ratio is historically expensive. From 2011 through 2020, for example, a 1.4x P/S ratio was more common. Plus, profit margins at the company have been slowly drifting lower for years, meaning those sales aren’t worth as much, in terms of profit, as they once were.
Despite its size, this latest low-margin NASSCO oiler award won’t make that trend look any better.
Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.