General Dynamics (GD) carries our highest investment recommendation of 5-STARS, or "Strong Buy", explains Colin Scarola, vice president of equity research at CFRA Research in the firm's flagship newsletter, The Outlook.

The firm is a diversified defense and commercial aerospace firm, with its most important products being integrated technology systems for the Department of Defense and military branches (around 30% of revenue), Gulfstream private jets (25%), nuclear submarines and destroyers for the U.S. Navy (25%), as well as armored tanks and vehicles for the U.S. Army (20%).

General Dynamics' 2020 revenue and EPS were down 4% and 8%, respectively, primarily due to a sharp drop in demand for Gulfstream jets (due to the pandemic), while Defense revenues grew 3% for the year.

With private jet demand quickly recovering as the global economy reopens, and Defense backlog up 8% in 2020, we expect GD to generate EPS growth of about 10% annually through 2023.

Given this healthy outlook, we think shares are highly undervalued at just 12x 2022 EPS consensus vs. 19x for the S&P 500. The primary factor weighing on GD's current equity valuation is sentiment, rather than weak fundamentals, in our view.

The conventional wisdom seems to be that demand for private jets will never fully recover, as the pandemic will lead to permanent reduction in business travel; and that flat or lower Defense budgets under the new Democrat administration will weigh on the firm's defense earnings.

We expect both of these sentiments will morph to optimism as 2021 progresses, leading to attractive multiple expansion for General Dynamics. The idea that business travel will be permanently reduced by virtual meetings, even after the pandemic, is a popular talking point right now, but we see evidence suggesting it is wrong.

From January to April 2020, U.S.-based business jet flights dropped 72%. But by last October, before the major resurgence of Covid-19 cases in developed economies, domestic flights for U.S.-based business jets had recovered to 1% above the January 2020 level.

With Covid-19 vaccines now rolling out across the world, we expect business travel to strongly rebound in the second half of 2021 and throughout 2022, driving a full recovery and strong future growth for the company's Gulfstream business.

Similar to our disagreement with the conventional wisdom on post-pandemic business travel, we don't think a Democrat as U.S. President will have a negative impact on major Defense firms like GD.

First off, we don't have to look back very far to see how defense firms fared during a period of shrinking U.S. Defense spending. After peaking at $699B in 2011, U.S. Defense spending was flat or negative for five years through 2016, declining at a five-year CAGR of -4%.

The top five U.S. Defense firms, including GD, grew average EPS 11% annually during 2012-2016, proving that earnings can grow while the budget shrinks.

The notion of Defense firm earnings growing while national Defense spending declines isn't as unusual as it seems after analyzing the U.S. Defense budget. Major Defense firms' contracts, including GD's, primarily come from the R&D and procurement portion of the Defense budget, which is only about 33% of the total. A much larger 61% is spent on things like personnel and operations.

History shows that when the Defense budget declines, it is not about political parties, but due to operation and troop draw downs, such as the Middle East drawdown in 2012-2015, or the First Gulf War and Cold War drawdowns in the early 1990s.

Our 12-month target price for the shares is $203, which is 15x our 2022 EPS estimate. This is below the stock's five-year forward P/E average of 16x to account for risk of a slower-than-expected recovery in Gulfstream demand and weaker-than- expected defense earnings.

General Dynamics shares have limited downside risk, though, as even if the firm fails to meet our growth expectations, its 2020 free cash flow already yields a highly attractive 7% on current market cap vs. 4% for the S&P 500.

This high free cash flow yield means General Dynamics can return significant cash to shareholders through dividends and buybacks even if there is no growth whatsoever over the next several years.

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