General Dynamics planted a yellow flag on earnings day.
General Dynamics (GD -0.20%) set a blistering pace for growth in the second quarter of 2024, reporting that its revenue grew 18% in comparison to last year’s Q2 — and its earnings grew 21%. So why were investors not impressed?
Shares of the defense giant slumped after earnings came out on Wednesday. And while those losses were pared in Thursday trading (the stock recovered about half of Wednesday’s losses), investors still seem unconvinced that General Dynamics’ growth path is for real, and that management can sustain it.
They may be right to worry.
General Dynamics by the numbers
General Dynamics takes a Joe Friday approach to reporting earnings — “just the facts.” Its earnings reports are typically heavy on numbers, but laconic on prose. Wednesday’s report was no exception, and didn’t need to be, with CEO Phebe Novakovic able to basically sum up the quarter in a single sentence: “This was a strong quarter overall, as reflected by solid growth in all key measures from a year ago.”
And what were those “key measures”?
Each of General Dynamics’ four main business divisions posted revenue growth in the quarter, with growth rates ranging from 2.5% at the company’s IT business to an incredible 50.5% in aerospace — the GD division responsible for building Gulfstream business jets. The company’s two most martial divisions meanwhile, marine systems (warships) and combat systems (tanks) posted strong growth rates of 13% and 19%, respectively.
So far, so good. But here’s where the news turns more mixed. Only two of the four divisions posted improved profit margins alongside sales growth. And one of those two was the IT unit (which had the weakest sales growth), while the other was combat systems — which was a strong grower, and also the company’s most profitable division, but still General Dynamics’ smallest revenue contributor. In contrast, both aerospace and marine systems saw their operating profit margins shrink.
A warning for General Dynamics investors
Those mixed results show why large corporations like General Dynamics diversify among multiple businesses, after all. If some businesses become less profitable, other businesses may become more profitable. Net-net, the changes should balance out and earnings growth can be steadier and more predictable as a result.
And indeed, that’s how things worked out for General Dynamics in Q2, with sales up and earnings up even more, despite a couple of lemons. What should perhaps worry investors more is what will happen to General Dynamics if sales do not grow, and more to the point, if sales actually shrink.
Because that may be the situation we’re facing today.
Even with only 500 words to work with, General Dynamics took time to forewarn investors that its book-to-bill ratio is not looking particularly healthy right now. This metric, which compares new orders for future work General Dynamics received in the quarter versus old work it took out of backlog, performed, and converted to revenue in the quarter, fell to just 0.8 in Q2. Put another way, for every $1 in work General Dynamics “billed” in the quarter, it “booked” new orders for future work worth only $0.80.
And that implies that General Dynamics’ sales growth — terrific in Q2 — could be getting ready to slow down a bit.
Is General Dynamics stock a sell?
Now, don’t hit the panic button just yet. General Dynamics isn’t in any danger of running out of work anytime soon. Companywide backlog is still a strong $91.3 billion, which means that General Dynamics has already “booked” enough work to keep it busy for the next two straight years, even if it takes in no new orders in that time. You should consider this more of a yellow warning flag, than a red flag indicating immediate danger.
Still, even warning flags fly for a reason. And this is the second quarter out of the last three in which General Dynamics’ book-to-bill ratio was less than 1, and less than the rate needed to maintain its torrid growth. (Analysts, by the way, see earnings growth slowing from Q2’s 21% rate to something closer to 14% on average over the next five years).
With General Dynamics stock currently trading for 22.8 times earnings and paying a respectable 2% dividend, the stock looks only modestly overpriced today. But should growth slow sooner than expected, this stock could begin to look even more overvalued than it already does.
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.